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Selecting ETFS For Long Term Investing - Key Metrics To Consider

May 15th, 2020

The best thing that has happened to individual investors in the last two decades is the emergence of Exchange Traded Funds (ETF).

ETFS are an amazing innovation in the investment industry landscape and can be easily called a game changer for many reasons. After the advent of ETFS it has become much easier for individual investors to follow passive investing and still get very focused exposure to a variety of asset classes. In addition, ETFS trade like stocks and thus is now becoming a security that's working for both traders and investors.

Passive ETFS track an index and has transparency in that investors will know at any time what stocks are components of an ETF. Low management fees in most cases and tax advantages are important merits that help the total assets continue to grow north of $4 Trillion.

As of writing, in the US, there are at least 2000 ETFS providing exposure to a variety of asset classes and leverage needs. So it is indeed becoming very difficult and challenging for individual investors to pick ETFS for their portfolios from among this wide selection. This is especially true for long term investors.

In our experience using ETFS both for investing and trading, we have found these metrics important while reviewing them for long term investing.

Track Record

Selecting ETFS that have a track record of at least 5 to 10 years and most importantly have survived recessionary and bear market environments is vital, especially in these volatile and uncertain environments. We have found over these 15 years of investing in ETFS, many shutting down in a year or two after arriving with a bang promising excellent results. If there are no takers over the long term the issuers have no choice but to wrap them up. For long term investors this will be big blow.

Management Fees

ETFS are predominantly focused on passive investing as they seek to track the performance of a benchmark or index (such as S&P 500). This is to be contrasted with active investing where money managers actively select securities to beat an index. So investors should be mindful of management fees as they do eat into returns over time. Investment companies such as Vanguard have some of the lowest fee levels being charged for ETFS in the industry.

Liquidity and Shares Outstanding

ETFS that have liquidity are generally preferred to thinly traded ones. In thinly traded ETFS there is typically a large gap between the bid and ask prices and investors don't get a good deal either when they try to buy or sell. ETFS that are usually starting out unless they are positioning to an attractive niche have thin liquidity and long term investors may be better off monitoring improvement in liqudity before putting money in them.

Another metric which highlights the broader demand for an ETF is the number of shares outstanding. A higher number indicates more shares have been issued and its market cap also tends to be higher. If demand for an ETF is high it usually means more investors are finding it investable.

Quality of Components

Not all ETFS that provide exposure to an asset class have the same quality or risk profile. It is important for individual investors to take a look at an ETF's components and review the basket. A somewhat diversified basket of good quality stocks in the chosen industry groups may be beneficial for the long term prospects of an ETF.

Tracking to Index

An ETF's performance is expected to closely track the performance of the index it is tied to. If a large tracking error is seen then it usually means the portfolio is not being efficiently managed, even though passively, in efforts made to track the returns of the benchmark. Fund Managers employ different approaches to track their benchmarks and inefficiencies in the methodology adopted could cause tracking errors.

Considering these metrics while selecting ETFS can help in filtering out many ETFS which may not be very beneficial for long term investors.

To note, some of the factors highlighted above may not necessarily apply when ETFS are used as trading vehicles. Traders try to time the market and frequently enter and exit positions and hence the yardsticks differ when they buy or sell ETFS. ETFS that provide leverage are more used by traders than investors. Some portfolios do make use of leveraged ETFS in appropriate allocation weights to obtain a slight outperformance over the benchmark.

Good Luck and Safe Investing!