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