How You Can Choose the Best Equity ETF
By Barbara Friedberg
Sometimes too much of a good thing really is too much. Psychologists Sheena Iyengar and Mark Lepper published a highly-cited consumer behavior study that found shoppers bought more jam at an upscale market when presented with only six choices versus a display table with 24 varieties.
While marketers and fund managers ascribe to the more is a better approach, this isn’t necessarily helpful for investors. The jam example and others studies show consumers frequently feel inundated with too many choices, causing avoidance of decision paralysis.
Investors may be overwhelmed with more than 1,500 equity exchange-traded funds. Despite countless choices, picking an equity ETF can be simplified. In fact, research shows that market-matching ETF investing performs better than actively managed funds most of the time.
With choices ranging from SPDR S&P Software & Services ETF to smart beta funds, such as the iShares Russell 1000 Growth ETF, there’s an equity ETF for every type of investor. An investor can even stick with the legacy Vanguard Total Stock Market ETF and get U.S. equity exposure with one fund.
Take Steps to Evaluate an ETF
Stephan Biggar, director of financial services research at Argus Research in New York, offers a sensible three-step plan for picking an ETF.
He says the first step is to consider whether the top 10 to 20 holdings in the fund fit in your investment criteria and aren’t failing stalwarts, such as General Electric Co. or J.C. Penney Co.
Biggar says to then look at cost. He recommends keeping expense ratios below 0.25 to 0.3 percent, excluding international funds, which might charge more. Finally, he recommends liquid and actively traded funds with bid-ask spreads at no more than 2 cents.
Another factor to add to the ETF evaluation toolbox is the tracking error. It makes no sense to choose a low-fee ETF if it does a poor job of replicating the returns of its benchmark index. Investors choose passive index funds to capture the market returns.
“The fit of an ETF can be determined by its tracking difference and the smaller the better,” says Daniel Taylor, founder of Taylor Morgan Capital Management in Dallas.
But other financial professionals have their own take on picking equity ETFs.
Shawn Johnson, the founder at Guidon Global in Boston, says that if investors stay away from leveraged, actively managed, and smaller ETFs, the pool of viable equity ETFs shrinks substantially. These actively managed ETFs are fine for sophisticated investors with specialized investment strategies. But most investors will do well to keep it simple.
Consider ETFs With Broad Diversification
For the investor seeking simplicity, Daniel Ruedi, financial advisor at Ruedi Wealth in Plano, Texas suggests a diverse ETF. For a one-stop equity ETF, he recommends the Vanguard Total World Stock ETF. It’s an all-stock portfolio, style-pure with no bonds or cash; it covers a representative sample of the U.S. and international equity market. Investors shouldn’t fear a lack of diversification with this fund, since it owns more than 8,000 stocks that represent both U.S. and international companies that operate in developed and developing countries. VT tracks the FTSE Global All Cap Index and charges a management-expense ratio of 0.1 percent.
When delving into specific stock ETF strategies, investors should take a look at stock ETFs as an extension of their own investment values, says Rob Isbitts, founder and chief investment strategist at Florida-based Sungarden Investment Research. For someone who values earnings quality and dividend growth, Isbitts recommends selecting ETFs that mirror those styles. There are many dividend aristocrats ETFs from which to choose, including the SPDR S&P Dividend ETF and the ProShares S&P 500 Dividend Aristocrats ETF.
But passive market matching investing strategies aren’t for everyone. Despite the proven studies that stock market index returns outperform those of actively traded funds most of the time, there are those investors who want to surpass market returns.
Peter J. Creedon, CEO of New York-based Crystal Brook Advisors asks, “Why not look for the 20 percent of active managers that outperform the passively managed index funds?”
But he counsels investors to consider risk and seek out actively managed ETFs with comparable risk in their passively managed funds.
Explore Socially Responsible ETFs
There are also socially responsible stock ETFs that include companies that are cognizant of environmental, social and corporate governance impact, says B. Scott Sadler, founder and president of Atlanta-based Boardwalk Capital Management, on investments that can also garner matching returns. Many of these socially conscious funds reap returns that are comparable or better than their index-fund counterparts.
Sadler recommends iShares MSCI KLD 400 Social ETF. The fund holds 402 stocks and is composed of U.S. companies with positive environmental, social and governance characteristics. The top companies in this fund include Microsoft Corp. Facebook, and Alphabet to name a few.
The DSI expense ratio is around 0.25 percent and the returns are impressive. The one, five- and 10-year annualized returns for DSI are 16.57, 12.72 and 11.32 percent, respectively. In comparison, the SPDR S&P 500 ETF returned 7.16, 11.19 and 13.14 percent during the prior one, five- and 10-year periods.
To choose the best equity ETFs, investors need to decide whether they want market-matching returns or an attempt to beat the market. For an ETF portfolio that allows an investor to set it and forget it, they should choose a few index tracking funds and avoid the hundreds of specialized equity ETFs. Experts say to cover the world of equity investments, a total stock market U.S. equity ETF combined with an all-world ex-U.S. fund will do the job.