It is easier, and often more important, to avoid mistakes than to identify great investment ideas. Among the low-hanging fruit, you can improve your odds of success by avoiding strategies that cost too much, take too much risk, or are poorly constructed. Unfortunately, the ETF landscape is littered with funds that suffer from these problems, and it’s not always obvious which funds do. But you can identify them if you know what to watch.
How do you know whether an ETF is charging too much? The most obvious cases are when two or more funds offer very similar exposure, but one charges a multiple of the cheapest option. Even when there are bigger differences between two similar funds, it is difficult to justify paying for the more expensive option. Some funds may look distinctive on the surface but just repackage exposures you can get elsewhere more cheaply.
Too Much Risk
It is hard to come back from a large loss. While it’s necessary to take some risk to earn more than the paltry rates Treasuries offer, the riskiest funds rarely offer commensurate compensation. Plus, riskier funds are tough to use well, as the pain of the losses they inflict can cause investors to dump them at the wrong time.
What constitutes too much risk varies across investors, but there are objective performance and portfolio characteristics investors can use to gauge a fund’s risk. Although no two market downturns are exactly alike, a fund’s performance during past downturns is a good measure of risk. Strategies that have significantly underperformed their category benchmarks during market downturns will likely continue to expose investors to greater downside risk. The datapoint “downside capture ratio” can help. This ratio shows how the fund performed in months when a broad benchmark (the S&P 500 for U.S. equity funds) was down.
Standard deviation of returns is also a useful risk metric. It shows how much a fund has bounced around. Funds with greater volatility tend to have greater downside risk than their less-volatile counterparts.
It is useful to pair this backward-looking risk data with an assessment of the composition of the portfolio, which can highlight risks that aren’t always apparent in funds’ historical performance. Funds with concentrated exposure to individual stocks or sectors often take risks that the market does not compensate. That may not be a problem if investors keep allocations to those funds small, but concentration risk bears watching. If a fund invests more than half of its assets in its top 10 holdings, it probably isn’t well-diversified. Aggressive style tilts, including value, growth, or dividend income, can also be a source of risk.
Poor Index Construction
While it is more difficult to objectively assess the quality of index construction than risk and fees, poorly constructed indexes are sometimes easy to spot. The most obvious index construction problems involve nonsensical stock selection and weighting criteria— those that lack sound economic rationale. Sometimes, an index’s selection criteria pass muster, but its approach to weighting securities doesn’t make sense.
It’s also important to be on the lookout for index strategies that are not designed for capacity because they can grow increasingly disadvantaged as they become more popular. Index reconstitution triggers a series of forced trades that can put upward pressure on the prices of newly added stocks and downward pressure on constituents slated for removal. This process is called rebalancing drag, and it can hurt the index’s performance. The more money that tracks the index, or the less liquid its holdings, the larger the rebalancing drag. To mitigate drag and increase capacity, most indexes screen their holdings for liquidity and apply buffer rules to reduce unnecessary turnover, but some do a better job than others. The Russell 2000 Index illustrates how rebalancing drag can hurt performance. At the end of May each year, it ranks U.S. stocks by market cap, targets those ranking between the 1,001st and 3,000th largest, and weights them by market cap. This gives it greater exposure to micro-cap stocks than many of its index peers, which tend to be more expensive to trade than larger stocks. And it requires only 5% of a stock’s shares to publicly trade to qualify for inclusion, which can pull in some thinly traded names. Most other indexes require at least twice that percentage. Russell does apply modest buffers around its upper market-cap threshold to reduce turnover, but it doesn’t apply any buffers around its lower bound, where trading tends to be more expensive.
These limitations, coupled with the large pool of money tied to the index, have created a significant rebalancing drag that puts it at a disadvantage to its small-cap index peers. It has consistently underperformed the MSCI USA Small Cap, CRSP US Small Cap, Dow Jones US TSM SmallCap, and S&P SmallCap 600 indexes from July 2001 through September 2017, as shown in Exhibit 1. This underperformance could not be attributed to differences in size or valuations.
• Avoid funds that charge several times the fee of similar alternatives.
• Performances during market downturns, volatility, portfolio concentration, and style tilts serve as useful measures of risk. Avoid the riskiest funds in each category.
• Not all indexes are well-constructed. Worthy index funds should be backed by sound economic rationales and take steps to mitigate rebalancing costs.