How to invest in ETF’s

What is your ‘ETF’ objective?

Managing Beta (Risk Management)

  • The beta (β) of an investment product or portfolio is a number describing the relation of its returns with that of the financial market as a whole.
  • An asset with a beta of 0 means that its price is not at all correlated with the market. A positive beta means that the asset generally follows the market. A negative beta shows that the asset inversely follows the market; the asset generally decreases in value if the market goes up and vice versa.
  • ETFs can be used to manage an individual investors portfolio Beta and improve portfolio diversification by adding uncorrelated instruments/ asset classes to existing portfolio in the following ways:
    • Invest in global, hard to access asset classes, countries, sectors
    • Use long and short ‘asset class’ trades to implement macro views.
    • Achieve strategic and tactical asset allocation objectives

 Seeking Alpha (Returns Maximization)

  • Alpha (a) is a risk-adjusted measure of the return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess the performance of an actively managed portfolio.
    • If a < 0: the investment has earned too little for its risk taken
    • If a = 0: the investment has earned a return adequate for the risk taken
    • If a > 0: the investment has earned returns in excess of the risk taken
  • ETFs can significantly increase the alpha on your portfolio by offering opportunities to invest in markets or asset classes where an individual investor in the US has no access or expertise.
  • While these alternative investment themes, sectors, styles and geographies may carry a higher risk than index funds, some interesting calendar year returns (for 2009) are as below:
    • S&P 500 (ETF: SPY) 86% (Benchmark)
    • Emerging Markets (VWO) 63%
    • MSCI Brazil Index (EWZ) 03%
    • Short 20+ yrs. T-Bills (TBT) 03%
    • Base Metals (DBB) 37%
    • Long Aussie Dollar, Short USD (FXA) 91%
    • International Real Estate (RWX) 66%

Other Objective

  • Besides risk and/ or returns, some other investment objectives for using ETFs could be:
    • Planning for retirement or other ‘life event’ (college, marriage etc.)
    • Building a core / satellite portfolio strategy
    • Managing cash/ liquidity

Creating a plan

 Select a benchmark/ target rate of return

  • Your risk appetite will automatically be defined depending on whether your objective is to manage risk or maximize returns.
  • In either case setting a benchmark rate of return is essential to establish an element of accountability in your ETF investing decisions.
  • If the objective is primarily portfolio diversification, some ETFs that could be used to benchmark returns for the different asset classes are as below:
    • US Equities:                                     SPY
    • Emerging Market Equities: EEM
    • Fixed Income: AGG
    • Commodities: GSG
    • Currencies: DBV
    • Real Estate: IYR
  • If the objective is to seek alpha, the benchmark or target rate of return could be a broader based total market index such as the Total Stock Market Index (VTI) or even the S&P 500 (SPY).

Setting a Risk/ Reward Ratio

  • If the individual investor plans to take on exposures in some niche asset classes/ themes/ geographies or sectors that have a volatility that is higher than that of the benchmark ETF – the investor should work with stop loss and take profit percentages.
  • This can be defined with the help of risk/ reward ratios. For instance a risk reward ratio of 1:1 with a risk tolerance of 10% would mean that the investor would compulsorily have to exit the position if the price of the ETF goes either 10% above or 10% below that of the benchmark ETF.

Time Horizon

  • The investor should also set a time horizon for the investment. Such a timeline could be short term (less than a year), mid-term (between 1-3 years) or long term (more than 3 yrs).
  • Ideally the investor should track his ETFs performance against the benchmark on a weekly/ monthly/ quarterly basis.

 ETF Risk Checklist

  • Liquidity Risk – Are the market capitalization and trading volumes of the ETF within acceptable norms? Is the quoted Bid/ Ask spread too wide?
  • Label Risk – Does the ETF accurately represent the asset class/ geography/ theme/ sector that you wish to invest in?
  • Tracking Error Risk – Have you read the prospectus and understood the following aspects about your ETF:
    • The process by which the ETF tracks the underlying asset class/ index
    • The ETFs Total Expense Ratio and timing of deduction of expenses
    • The ETFs Dividend distribution policy
    • The frequency / time lag in rebalancing of the ETFs portfolio to reflect changes in the underlying index/ asset class composition
    • The difference in time zones (if any) between the ETF and underlying index/ asset class.
  • Tax Risk – What is/ are the Tax rate(s) applicable to the ETF?
  • Counterparty Credit Risk – Is the Sponsor an established provider or a new entrant? What are the total assets under management?

Transaction Costs

Brokerage

  • Given that ETFs trade like any other share – investors have to pay brokerage every time they buy and sell ETFs. Therefore, investors should plan to invest a minimum of $4,000 in one transaction so as to keep brokerage transaction costs under 50 bp (assuming brokerage of $10 per transaction).

 Expense Ratio

  • The Total Expense ratio (TER) that includes shareholder transaction costs and annual management fees for ETFs can be as lower than 10 bp and in some cases higher than 100 bp. On average investors should expect to pay about 35-40 bp as TER for investing in ETFs.

Transaction Execution

  • ETFs can be bought for delivery, bought on margin, sold for delivery and /or short sold through any stock broker.
  • Transactions can be executed in any of the following methods:
    • Online (E*Trade, Scottrade, TD-Ameritrade, Fidelity etc.)
    • Over the phone with your Stock Broker
    • Through your Financial Advisor/ Investment Manager