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The universe is expanding, and that’s not just a reference to astrophysics. The realm of exchange-traded funds (ETFs) is growing, too; investors have thousands to choose from. More than 500 ETFs are traded on the Toronto Stock Exchange alone.

While they are lauded for providing low-cost diversification, liquidity and tax efficiency, not all ETFs are created equal.

How does an investor make sense of this universe? Consider that ETF also stands for Efficiency, Tradeability and Fit, says Elisabeth Kashner, director of ETF research for FactSet Research Systems Inc., which provides financial data and analytics for the investment industry.

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Look beyond fees when examining an ETF, experts advise.

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Efficiency

ETFs are popular because they are considered efficient investments, providing diversified exposure to markets along with highly competitive costs, or management expense ratios (MERs). An ETF is considered efficient if it closely tracks its underlying index, especially in the case of passive funds that aim to emulate their benchmark.

In general, the higher the MER a fund charges, the more it will deviate from the performance of its underlying index. So a fund charging a MER of 0.1 per cent will generally track its index more efficiently than one charging 0.7 per cent.

Fortunately, “ETFs function very smoothly so you won’t get a lot of additional slippage beyond the expense ratio,” Ms. Kashner says.

Moreover, the spread between index and ETF performance is negligible when a fund is held for longer periods, she adds.

But efficiency can be problematic with more complex ETFs. An example might be a fund that uses an active strategy of selecting stocks based on upward price momentum. Not only would its MER be higher, but the funds may require more rebalancing of assets to maintain the strategy.

This can result in higher trading and tax costs, and they in turn reduce efficiency in tracking the underlying index or, in the case of many active-management ETFs, beating the benchmark, says Alan Fustey, portfolio manager with Index Wealth Management in Winnipeg.

That’s why investors should examine an ETF’s performance history relative to its underlying index to see how well they match up.

Tradeability

For the most part, ETFs are easily tradeable, partly because they are so liquid. But there are two types of liquidity, says Lara Crigger, senior editor with ETF.com. There’s the liquidity of the ETF itself, and then the liquidity of the underlying securities. "And those two aspects don’t always inform each other,” she says.

Where investors run into trouble is with large, popular ETFs focused on small sectors. Ms. Crigger points to the VanEck Vectors Junior Gold Miners ETF (GDXJ). “This ETF became such a large shareholder in a few of the underlying [small cap] companies that it got super close to the 20-per-cent threshold where the ETF would have needed to make a takeover offer.”

Additionally, the fund had grown so large and concentrated that it nearly lost its preferential tax status under U.S. law. “To get around this, GDXJ had to start buying up companies that weren’t in its underlying index, which increased its tracking error,” reducing its efficiency.

Illiquidity can also affect the bid/ask spread, the amount by which the ask price exceeds the bid price during the buying and selling process. This is not an issue with large ETFs covering big markets, which may have bid/ask spreads of one cent, Mr. Fustey notes. “But with more lightly traded, factor-based ETFs, you can get spreads of about 40 cents.”

Fit

This third factor bears the most consideration because “fit” often has the biggest impact on whether an ETF fulfills your investment needs. “First things first, you need to understand the economic exposure you want,” Ms. Kashner says.

This might seem straightforward, especially for an ETF tracking a broad index. But investors get tripped up when choosing among multiple ETFs. “A utilities fund is a utilities fund is a utilities fund, right? Wrong, wrong, wrong.”

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Ms. Kashner adds that even in this fairly staid sector, a 10-per-cent performance spread in one year between ETFs is not unheard of because of differences in holdings and how those assets are weighted.

Even among large, passive funds, not all ETFs are what investors assume. For example, the Horizons S&P/TSX 60 Index ETF (HXT) uses a synthetic swap – a derivative strategy – to mimic the performance of the largest companies listed on the TSX. The benefit is that its MER is 0.07 per cent, Mr. Fustey says. Or you can buy the iShares S&P/TSX 60 Index (XIU), which is a basket of 60 stocks; it charges a MER of 0.17 per cent.

Yet unlike the XIU, the HXT presents counter-party risk, meaning there is a risk associated with the provider of the swap possibly defaulting and not being able to meets its financial obligation in the arrangement. This is not a big concern with this particular fund, because the counter-parties are the Canadian Imperial Bank of Commerce and National Bank of Canada, Mr. Fustey says. But it still highlights the importance of understanding what you are buying.

All too often, Ms. Crigger argues, investors focus on fees alone when they should also look at a fund’s contents.

“There are, for example, something like 110 equal-weighted ETFs listed in the U.S,” she says about the strategy in which equal weight is given to companies regardless of their market capitalization. So Apple Inc. and a smaller stock, for example, would have the same allocation. “Each one of them has different exposure, methodology and cost.”

What’s more is that investors often buy trendy ETFs without understanding their downside risk. Ms. Kashner cites one recent example in which investors piled into a currency-hedged European ETF that was “on fire” until the hedging strategy no longer worked, leading investors who bought high to sell low.

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“You don’t want to be that guy, and the way you avoid that is doing your homework.”

Reading the prospectus may be a little much, but investors should at least read the fund facts sheet. And if they do not understand its strategy, the choice is simple: Stay away. ETFs are generally designed to be straightforward and easy to use, even if the industry is creating more complex, exotic funds seemingly by the day, Ms. Crigger says.

“But that exotic ETF likely won’t serve you well if you can’t explain what it does to your grandma.”

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