Check ETF ingredients before choosing flavors

With nearly a thousand flavors now available at the ETF buffet, where do you even begin to fill your plate?

Start with the major food groups. A sound investing plan begins with intentional, reasoned allocations to distinct asset classes. While it is easy to become enamored with specific stocks or ETFs, determining how to spread investments across asset classes, based on expected risk and return, is the first step. These allocations will have a dominant role in determining overall performance of a portfolio.

Read the ingredient labels. After determining appropriate asset allocations, it’s time to truly understand what each ETF holds as funds vary widely and their names rarely tell the full story.

The vast majority of ETFs are index investments, meaning they are designed to track the performance of published indexes or benchmarks. But within any broad asset class one will find many indexes, each tracked by different ETFs with their own unique features. More on indexing

Examples of large cap US stock indexes

Different indexes, different approaches

Being in the same asset class does not mean that indexes will behave the same way. Here’s why:

• Some indexes have strict mathematical rules about when companies enter or exit. Others are highly subjective. For instance, the editors of the Wall Street Journal determine what stocks are included in the Dow Jones Industrial Average.

• Many flavors have sub-flavors. For instance, within large cap stocks, one finds not only broad indexes, but also those specific to style, industry or geography. Some use very exacting standards in choosing stocks. The S&P High Yield Dividend Aristocrats Index, for example, is one of several indexes that include only companies that have consistently raised dividends year after year. Other high yield ETFs.

• Rules for weighting stocks in an index may differ. The S&P 500, Nasdaq Composite and most other indexes weight stocks by market capitalization, while the Dow is price-weighted.

Different rules, different results

How ETFs are managed can make a big difference in performance. Vanguard’s VWO and iShare’s EEM are both designed to track the performance of the MSCI Emerging Markets Index. But their approaches vary considerably. VWO does it with about 900 stocks and EEM with less than 800. (The index itself includes about 800 companies.) The top holdings of the funds are not identical. Further, VWO’s published expense ratio is 27 basis points; EEM’s is 69 basis points. Because of these differences, over the last two years, VWO has outperformed its rival.

The different characteristics of indexes and ETFs described in this post are not meant to indicate which ETFs are “best,” only that the effect of seemingly subtle differences can be considerable. It is a dramatic case of caveat emptor – there’s no way to know what you’re buying without doing the research yourself or working with an advisor who has. It pays to be picky about ingredients.

For a pdf listing of all ETFs – more than 970 – compiled by State Street, click here.