It is easier, and often more important, to avoid mistakes than to identify great investment ideas. Among the low-hanging fruit, you can improve your odds of success by avoiding strategies that cost too much, take too much risk, or are poorly constructed. Unfortunately, the exchange-traded fund landscape is littered with funds that suffer from these problems, and it's not always obvious which funds do. But you can identify them if you know what to watch.
How do you know whether an ETF is charging too much? The most obvious cases are when two or more funds offer very similar exposure, but one charges a multiple of the cheapest option. For example, PowerShares Dividend Achievers ETF and Vanguard Dividend Appreciation ETF
both target U.S. stocks that have raised their dividends for 10 years straight, and both weight their holdings by market capitalization. In fact, VIG starts with the same portfolio as PFM, but it applies some additional proprietary screens to filter out names that are less likely to sustain their dividend growth. While VIG charges a low 0.08% expense ratio, PFM charges 0.55%. Given the similarities between the two funds (plus the extra screen VIG offers), there is no reason to pay up for PFM.
Even when there are bigger differences between two similar funds, it is difficult to justify paying for the more expensive option. IShares MSCI Emerging Markets ETF
(0.69% expense ratio) and iShares Core MSCI Emerging Markets ETF
(0.14% expense ratio) both provide market-cap-weighted exposure to stocks listed in the same countries. But IEMG offers more for less, extending its reach further down the market-cap ladder to yield a more comprehensive portfolio.
BlackRock launched IEMG in 2012 with a low fee to compete with Vanguard FTSE Emerging Markets ETF
, without having to cut the fee on its legacy EEM product. It argued that EEM's higher fee was justified because it had heavier trading volume (making it cheaper to trade in large blocks) and a deeper options market, making it more valuable to large institutional investors. But that liquidity gap is closing, and it is hard to justify such a large price gap. There is no good reason for individual investors to prefer EEM over IEMG.
Some funds may look distinctive on the surface but just repackage exposures you can get elsewhere more cheaply. For example, First Trust Large Cap Value AlphaDEX ETF (0.62% expense ratio) follows a unique portfolio construction approach, but investors could get similar exposure more cheaply with a market-cap-weighted alternative.
FTA ranks the stocks in the Nasdaq US 500 Large Cap Value Index on their value characteristics and targets the highest-ranking 75%, offering a slightly deeper value tilt than most market-cap-weighted value funds. It then divides its holdings into quintiles based on their rankings and assigns larger weightings to the higher-ranked quintiles. All stocks in the same quintile receive the same weightings, which pulls the portfolio toward smaller-cap stocks.
So, while this fund falls in the large-value Morningstar Category, it has tended to behave more like a mid-value fund. During the trailing 10 years through September 2017, FTA beat market-cap-weighted Vanguard Value ETF
(0.06% expense ratio) by 1.75 percentage points annually. But it lagged Vanguard Mid-Cap Value ETF
(0.07% expense ratio) by 45 basis points annually during that time. In fact, a regression analysis revealed that the mid-cap fund's performance could explain 93% of FTA's performance. Because it is possible to largely replicate FTA's performance with a fund that costs 0.07%, it is difficult to justify a fee of 0.62%.
Too Much Risk
It is hard to come back from a large loss. While it's necessary to take some risk to earn more than the paltry rates that Treasuries offer, the riskiest funds rarely offer commensurate compensation. Plus, riskier funds are tough to use well, as the pain of the losses they inflict can cause investors to dump them at the wrong time.
What constitutes too much risk varies across investors, but there are objective performance and portfolio characteristics investors can use to gauge a fund's risk. Although no two market downturns are exactly alike, a fund's performance during past downturns is a good measure of risk. Strategies that have significantly underperformed their category benchmarks during market downturns will likely continue to expose investors to greater downside risk. This data is available (labeled "downside capture ratio") on the Ratings & Risk page for each fund on Morningstar.com. This ratio shows how the fund performed in months when a broad benchmark (the S&P 500 for U.S. equity funds) was down. For example, PowerShares S&P 500 High Beta ETF had a downside-capture ratio of 159% during the trailing five years through September 2017, indicating that the fund lost 1.59 times as much as the S&P 500 in down months. That was one of the worst showings in the large-blend category.
Standard deviation of returns is also a useful risk metric available on the Ratings & Risk page. It shows how much a fund has bounced around. Funds with greater volatility tend to have greater downside risk than their less-volatile counterparts.
It is useful to pair this backward-looking risk data with an assessment of the composition of the portfolio, which can highlight risks that aren't always apparent in a fund's historical performance. Funds with concentrated exposure to individual stocks or sectors often take risks that the market does not compensate. That may not be a problem if investors keep allocations to those funds small, but concentration risk bears watching. If a fund invests more than half of its assets in its top holdings, it probably isn't well-diversified.
Aggressive style tilts, including value, growth, or dividend income, can also be a source of risk. SPDR S&P International Dividend ETF
illustrates the dangers of chasing dividend yield. It targets the 100 stocks with the highest risk-adjusted dividend yields (yield/volatility of that yield during the prior 36 months) from the S&P Global ex-US Broad Market Index and weights them by dividend yield to boost income. The fund does apply modest quality screens to filter out unprofitable stocks that pay out more than the cash flow they generate, but its narrow focus on yield still causes it to load up on risky names with poor growth prospects. Yield-weighting further increases risk by causing the fund to rebalance into stocks as their yields rise, which often occurs as prices fall and fundamentals deteriorate. As a result, the fund has tended to lag its parent index during market downturns and exhibit higher volatility. High yields are not a free lunch.
Poor Index Construction
While it is more difficult to objectively assess the quality of index construction than risk and fees, poorly constructed indexes are sometimes easy to spot. The most obvious index construction problems involve nonsensical stock selection and weighting criteria--those that lack sound economic rationale. ProSports Sponsors ETF FANZ is a prime example of a strategy that lacks sound economic rationale. It targets the stocks of companies that sponsor or broadcast major U.S. sports leagues and weights them equally. But there is no reason to believe sports sponsorship has any bearing on stock performance. The fund sweeps in an eclectic group of stocks, such as General Motors
, and Bank of America
, that don't have much in common other than the fact that about half of them are consumer-oriented (cyclical and defensive). Investors who are after consumer names would be better off in a consumer sector ETF.
Sometimes, an index's selection criteria pass muster, but its approach to weighting securities doesn't make sense. That's certainly the case for iShares Select Dividend ETF
, which targets high-yielding U.S. stocks. To filter out firms at risk of cutting their dividends, it requires new additions to have paid and increased dividends for the past five years and generated sufficient earnings to easily cover those payments.
So far, so good. But the index errs in weighting its holdings by the value of their per-share dividend payments. That's a terrible metric because it is linked to the number of shares outstanding, which bears no relation to firm value or the total value of the dividends each firm pays. So, if a stock splits its shares, its weighting in the index declines, even though that event has no impact on the firm's dividend policy or value.
While such a nonsensical weighting approach won't necessarily hurt performance, it can introduce some unintended biases. In this case, it pulls DVY into mid-cap territory and contributes to its large allocation to utilities stocks. As of this writing, the average market cap of the fund's holdings would be more than 5 times larger and its exposure to the utilities sector 14 percentage points lower if it weighted its holdings by market cap.
It's also important to be on the lookout for index strategies that are not designed for capacity because they can grow increasingly disadvantaged as they become more popular. Index reconstitution triggers a series of forced trades that can put upward pressure on the prices of newly added stocks and downward pressure on constituents slated for removal. This process is called rebalancing drag, and it can hurt the index's performance. The more money that tracks the index, or the less liquid its holdings, the larger the rebalancing drag. To mitigate drag and increase capacity, most indexes screen their holdings for liquidity and apply buffer rules to reduce unnecessary turnover, but some do a better job than others.
The Russell 2000 Index illustrates how rebalancing drag can hurt performance. At the end of May each year, it ranks U.S. stocks by market cap, targets those ranking between the 1,001st and 3,000th largest, and weights them by market cap. This gives it greater exposure to micro-cap stocks than many of its index peers, which tend to be more expensive to trade than larger stocks. And it requires only 5% of a stock's shares to publicly trade to qualify for inclusion, which can pull in some thinly traded names. Most other indexes require at least twice that percentage. Russell does apply modest buffers around its upper market-cap threshold to reduce turnover, but it doesn't apply any buffers around its lower bound, where trading tends to be more expensive.
These limitations, coupled with the large pool of money tied to the index, have created a significant rebalancing drag that puts it at a disadvantage to its small-cap index peers. It has consistently underperformed the MSCI USA Small Cap, CRSP US Small Cap, Dow Jones U.S. Small-Cap Total Stock Market, and S&P SmallCap 600 indexes from July 2001 through September 2017, as shown in Exhibit 1. This underperformance could not be attributed to differences in size or valuations.
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- Avoid funds that charge several times the fee of similar alternatives.
- Performances during market downturns, volatility, portfolio concentration, and style tilts serve as useful measures of risk. Avoid the riskiest funds in each category.
- Not all indexes are well-constructed. Worthy index funds should be backed by sound economic rationales and take steps to mitigate rebalancing costs.