From the February 2013 issue of Research Magazine • Subscribe!

January 23, 2013

Excelling With ETFs

Financial advisors should know by now that there’s more to successful ETF investing than simply buying the right funds at the right price. Other important factors, like a fund’s intrinsic value versus its share price and how well it tracks its benchmark, are crucial considerations. What guidelines are you using to help you be a better ETF advisor? 

Today, the number of ETFs available in the U.S. tops 1,100, making the selection and trading process daunting. And for that reason, it’s vital that brokerage firms and financial advisors create a due diligence framework for investing in ETFs. Here’s a checklist to help you set forth your own ETF best practices.

Know the Structures

The exchange-traded world generally uses the following product structures: open end fund, unit investment trust, grantor trust, partnership or ETN. Each product type has its own unique set of financial risks, tax treatment, and consequences. For example, an equity note like iPath MSCI India ETN (INP) might be more tax efficient and have less tracking error than the iShares India 50 ETF (INDY), but the note carries an additional layer of credit issuer risk. Do the advantages of the ETN outweigh its disadvantages versus the ETF? Advisors should know the answer before investing. 

Keep in mind that subtle structural differences can even impact something as important as the timing of dividend income. Both the iShares Core S&P 500 ETF (IVV) and the SDPR S&P 500 (SPY) track the S&P 500, but the timing of dividend payments is noticeably different.

For instance, a final dividend payment of 0.92 cent per share in 2012 for IVV was paid on Dec. 26 to shareholders of record on Dec. 21. But SPY didn’t pay its final 2012 quarterly dividend of $1.02 until Jan. 31, 2013 or just over 30 days after its record date! Why the difference? Dividends in open end funds like IVV are immediately reinvested and paid to shareholders, whereas SPY’s unit investment structure holds onto dividends, creating a dividend drag.  

Check Intraday NAVs

What’s the value of the underlying securities your ETF owns? The “indicated net asset value” or INAV will tell you. At Yahoo Finance, type ^ followed by the fund’s ticker symbol and then –IV. Compare that to the ETF’s market price and if the INAV trades at a premium, wait until it narrows. Generally, actively traded U.S. stock ETFs should trade within 0.1% of their INAV. Keep in mind that INAV may be static for certain ETFs linked to certain commodity, bond or international markets where the underlying securities are closed for trading even though the ETF is trading. 

Monitor ETF Spreads

The ETF “spread” is the difference between the “bid” price (what buyers are willing to pay) and the “ask” (what sellers are willing to receive). Wider spreads add to your trading costs, so stick with ETFs that have tight bid/ask spreads. Before buying an ETF, check the bid/ask spread and see how it compares with similar funds. Many ETF sponsors will provide regular updates on bid/ask spreads of their products at their websites. Morningstar.com reports ETF bid/ask spreads in percentage terms to illustrate estimated trading costs. Spreads for heavily traded ETFs can be as little as one penny.

Avoid Opens and Closes

At the market’s open, it is common to see wider ETF bid/ask spreads because not all of the holdings within the ETF may be trading at the open. Wider bid/ask spreads are bad because they increase your trading costs. Toward the market’s close, “Authorized Participants” or “Aps” as they’re known may be reluctant to take on large positions because they want to balance their books and go home, and that can lead to larger than usual spreads on ETF bid/asks. Generally, keep a 30-minute window between ETF trades for the open and the close as a good rule of thumb. 

Watch Tracking Error

“When advisors are selecting ETFs to build asset allocation models for their clients the first and most important criteria for selection is the fund’s tracking error from the index,” says Darwin Abrahamson CEO and founder of Invest n Retire. “When you are benchmarking to indices advisors want the closest performance to the index.”

Although ETFs may track the same index, there may be variances in performance because funds may not hold all of the securities in the index or the securities may have different weightings than the index. Funds with substantial tracking error raise red flags. 

Use Limit Orders

How can you avoid unpleasant surprises when trading ETFs? “Do not forget to use some type of limit order when buying or selling ETFs,” advises Noah Hamman, CEO of AdvisorShares. “Markets can be volatile and choppy when you least expect it.” 

ETF limit orders are instructions to buy a fund at a maximum price or to sell it at a minimum price. If filled, the order will only be executed at your specified price or better.

Also, use stop loss orders as a disciplined way to protect clients from escalating losses. Generally, a 7-10% stop loss is a good rule of thumb. With more volatile securities or leveraged ETFs, you may decide to increase your stop levels. Place stops as good till cancelled (GTC) or use day orders. Lastly, when the price of your ETF increases in value, don’t forget to increase the price of your trailing stop loss order. Limit orders help you to manage both risk and execution costs. 

Don’t Look Back

Mutual fund and ETF research often focuses on historical performance data, which doesn’t tell you much about the future. “Where we caution people is on using backward-looking metrics, because they don’t work,” says Suzanne Cook, President at StockSmart. “You can’t drive a car that way and can’t drive a fund or ETF that way.” 

Cook suggests using a stock-like approach in investing in ETFs. Advisors should ask: What is the valuation on forward looking PE? What is the earnings outlook for the component holdings inside the ETF? What does technical analysis tell you about the ETF? These are all forward metrics that advisors should be watching. 

 Employ Margin Sparingly 

Trading with borrowed money can magnify returns, but it can also magnify losses. Before trading ETFs on margin, ask the following questions: (1) Do the clients have a high tolerance for risk and volatility? (2) Do they fully understand they can lose more money than they’ve invested? (3) Do they understand they may be forced to sell some or all of their securities when falling prices reduce the value of their portfolio? (4) Do they realize they may have to make additional deposits of cash or securities to cover market losses? 

Conclusion 

Building a solid framework of ETF best practices makes you better equipped to meet your clients’ unique financial goals. It also increases the value of your advisory role and helps clients to understand there’s more to ETF investing than simply picking funds with the lowest expense ratios.

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