A Strategy for Picking ETFs

Since the first ETF was launched in 1993, assets under management have increased to $830 billion as of April 30, 2010. Over the last 10 years the compound annual rate of growth in ETF assets has exceeded 30%. The remarkable success of ETFs is grounded in their many advantages over actively managed open-end mutual funds. ETFs offer intraday liquidity; open-end funds can only be purchased once per day at the closing price. ETFs disclose their entire portfolio daily; open-end funds are only required to disclose their portfolios semi-annually. Through the use of in-kind transfers, ETFs are able to reduce capital gains distributions to a pittance of what is common in open-end mutual funds. And the average expense ratio of ETFs is a fraction of the average expense ratio of open-end funds. There is simply no denying that ETFs are superior to open-end mutual funds.

The popularity and growth of ETF assets under management have created a gold rush of sorts in the fund management business. There are now over 900 ETFs in the market and another 630 in registration. Wall Street brokerage houses are even starting to get in on the action. Schwab recently launched its own family of ETFs, Jefferies has come to market with a few ETFs, and even Goldman Sachs is preparing to enter the ETF space. When Wall Street discovers a new profit center, it often takes it to excesses.

With 900 ETFs now trading, there are of course already excesses in the marketplace. Ninety percent of the ETFs trading today are not worthy of your investment consideration. Does Wall Street really think that investors need 26 different health-care index ETFs? I certainly don’t.

At Young Research we weed out unworthy ETFs by first sorting all funds by investment category, such as large-cap, small-cap, utilities, industrials, etc. Then, for each category, we focus on three numbers: dollar volume, assets under management, and expense ratio. We keep only those funds with the highest dollar volume and assets under management and the lowest expense ratio. This greatly narrows the list of funds worthy of investment consideration. We then conduct deeper analysis on the remaining funds to choose those that are the most attractive. If you don’t take a similar approach to ETF selection, you are doing yourself and your family a grave disservice. Illiquid ETFs with high expense ratios are no better than load funds with 12b-1 marketing scabs that are aggressively promoted to unsuspecting investors.