Fashion titan Karl Lagerfeld, known for his iconic fashion and outspoken nature, famously said, “Trendy is the last stage before tacky.” He was referring to clothing trends, but the same concept can be applied to investments. Especially during a time when flashy marketing seems to outweigh prudent strategy.
Exchange-traded funds, or ETFs, have become one of the most popular investment vehicles in recent years. Mainly because they give investors what they want: low fees and competitive returns. They’re easy to buy and prolific. The trouble is, it can be difficult to evaluate ETFs as an investment.
What Do ETFs Really Offer?
Exchange-traded funds are investment vehicles consisting of stocks that track an already established index, such as the Standard & Poor’s 500. They trade like a stock, as opposed to open-ended mutual funds, and they work well to give broad exposure to sector moves and indexes.
They don’t have to track an index, however. Many ETFs are more thematic and allow exposure to smaller sections of the market, like medical devices or cryptocurrency.
When is it Advisable to Have a Narrow Strategy, as Opposed to Broad Exposure Through Index Funds?
To help shed light on the topic of ETFs, I consulted Janelle Nelson, active investor, and finance professional of 33 years. Nelson recently retired after a 23-year role as portfolio analyst with the U.S.-based wealth management firm of the Royal Bank of Canada.
She recommends always looking at the liquidity of the underlying securities and making sure they can easily be traded. “Sometimes one underlying stock comprises 30% or 40% of an ETF. It might make more sense to buy the stock outright.” Nelson said.
An exchange-traded fund is often a good choice if you’re trying to gain exposure to specific regions or countries, that may not be easily accessible for individual investors. Samsung, for example, doesn’t trade easily on major U.S. Exchanges but you could buy a South Korea ETF for country exposure; Samsung comprises just over 22% of the iShares MSCI South Korea ETF (NYSE: EWY).
How Can You Tell a Gimmick from a Legitimate Theme or Sector?
“You should make sure to own quality ETFs with a strong sponsor,” Nelson said, adding that the liquidity and nature of the underlying securities is always the first step when evaluating an ETF. They may be easy to buy into, but getting out at the right time is where people either make or lose money.
With smaller, newer ETF sponsors, industry monitor ETF.com suggests looking for funds with at least $50 million in assets under management, especially is the issuer isn’t strong. A fund that fails to gather at least $50 million in assets under management may be at greater risk of folding, unless it’s a small fund operated by a bigger sponsor, such as Fidelity or Vanguard, or any big brokerage. It’s not necessarily the case that a small ETF from a relatively unknown sponsor will fail, but it’s something to keep in mind.
If an ETF fails to attract enough assets to cover costs because of low investor interest, it can close, which, as reported by industry tracking sites, happens regularly. This can leave investors with a tax burden or reinvestment risk.
When it comes to liquidity, in order for a “hot ETF” to be created, the sponsor must believe there’s already demand for it. “If the ETF has already been created, you’re generally not at the beginning of the curve, you’re often at the middle of the curve,” Nelson said. “ETF sponsors have to anticipate enough demand for it to attractive investors and provide returns. Regulators need time to put it through the regulatory process. If an ETF is built on a hot theme, that theme is usually already widely publicized. It’s being created for something that’s often a foregone conclusion.”
When making money is the goal, Nelson continued, “you want don’t want to be the last one [to buy] in. With a hot ETF, you may be both the last one in, and the last one out.”
For investors, a danger with thematic ETFs is coming late to the party, once the theme is well known and hyped, and the rally has already happened. Unfortunately, many who are drawn to these themed ETFs are not early adopters, and only pile in once the trend is well established. Sure, the fund may rally again at some point, but late adopters can be easily discouraged, and rush for the exit, rather than sitting patiently.
Take this Forbes article, for example, sharing an opinion on a bitcoin ETF. The author points out: Everyone who cared enough to figure out how to buy into cryptocurrency probably already has, and a bitcoin ETF would trail the real marketplace.
Nelson cites the example of the iPath S&P 500 VIX Futures exchange-traded note, which tracks the Chicago Board Options Exchange Volatility Index, often dubbed the VIX.
According to Nelson, “The ETFs that often encompass the most risk, are those that try to replicate or exaggerate moves in volatility or a narrow segment of the market – like the VIX for example; make sure they do what they are set out to do.”
The CBOE Volatility Index is considered a forward-looking indicator, pegged to the buying and selling of S&P 500 options. If investors are showing more inclination to sell, that’s a sign they are worried about the market in the near term.
Last year, the historically low volatility may have dulled investor’s senses to normal market activity. In other words, many may have become complacent about the potential for higher volatility.
When purchasing an ETF, do your homework and understand if the individual companies making up the fund replicate the sector or theme for the reason you’re investing in it. How is created? What has the track record been vs. its theme or index?
The Question You Should Always Come Back To
Does this investment give you your intended or desired outcome? Making money is not the only outcome; ask yourself if it fits into your overall investment philosophy and the asset mix you need to achieve a goal, such as retirement.
Nelson has some great advice that’s easy to follow. It comes as an acronym: WHY.
- What is it?
- How does It work?
- You: What is your objective and how does the investment fit in?
And if a particular ETF (or any financial product) sounds too good to be true, it probably is. “There is no free lunch on Wall Street. If you’re not sure what the product is; you’re the product” Nelson added.
Consider if you’re buying something just because it’s available, or it meets your needs. Harem pants and a crop top? Not for everyone. I shudder at the thought…