Every day it gets harder for investors to put together a simple, sensible portfolio of exchange-traded funds.
Literally.
There were 180 new ETF products introduced globally in the first half of 2009, virtually one a day. Some 1,707 ETFs are listed on exchanges around the world, almost 900 of them easily available to Canadian investors on either the TSX or U.S. exchanges. Wondering how to find a few good ETFs for your portfolio?
Help is at hand. In this edition of the Portfolio Strategy column, we build an ETF screener using the same criteria as professional money managers. Use it to help evaluate any ETF you're considering for your own portfolio.
Step One: Fees
The main reason that people use ETFs to build portfolios is that they are a very cheap way to create a fully diversified portfolio. But the proliferation of ETFs in recent years means that some ETFs are much cheaper than others.
“There are often 10 ETFs tracking the same index,” said Tyler Mordy, director of research for money manager Hahn Investment Stewards. “We'll take the cheapest one, thank you very much.”
Mark Yamada, president of PUR Investing, said low fees are paramount to him as well: “We're looking for the cheapest exposure.”
Note: You don't automatically buy the lowest-fee ETF, period. Instead, Mr. Mordy and Mr. Yamada go for the lowest-cost ETF that meet their other investing criteria.
Step Two: Trading Volume
There are two reasons to pay attention to the number of shares an ETF trades in a typical day, one of them being that thinly traded funds can be terminated. This could tie your money up for a while, although you will, in the end, receive the net asset value per share.
Another reason to pay attention to trading volumes is that buy and sell pricing gets less competitive for unpopular funds. Worst case, you have to accept less than the market price to get out of an ETF you own, or pay extra to buy.
Mr. Mordy said his firm only looks at ETFs that have an average daily volume of 50,000 shares over the previous three-month period, and that have a market capitalization (that's shares outstanding multiplied by share price) of $100-million or more.
Doesn't that eliminate a huge number of ETFs? “Totally,” he said. “You strip out all the esoteric crap. That's what you should be doing.”
Chris Young, a financial adviser with Manulife Securities, said he looks only at ETFs that have an average daily trading volume of 100,000 shares. “If you're looking to filter the number of ETFs down, that's a good way.”
This is true. Of the 120 ETFs listed on the Toronto Stock Exchange, only a few dozen may trade 100,000 shares a day.
Step Three: Diversification
ETFs are a great diversification tool because they allow you to invest in an entire index of stocks or bonds through the purchase of a single exchange-traded security. But some indexes, particularly those in sectors of the broader market, are dominated by a few particular stocks. If these stocks get hammered, the entire index could fall hard.
At Hahn Investment Stewards, they have a rule that no one stock or bond can account for more than 10 per cent of the total portfolio. PUR Investing specifies that the Top 10 holdings of a fund should account for no more than 20 per cent of total assets.
Step Four: Index Construction
Traditional indexes weight stocks according to their market capitalization, which is to say the biggest companies dominate an index. In an effort to provide a more effective mix, newer fundamental indexes factor in revenues, dividends, book value and cash flow when weighting stocks.
