Before You Invest in an ETF or Index Make Sure You Understand Them

At the moment, investing in ETFs and index funds are all the rage. Unfortunately, what an investor believes they are getting may not be what they actually get. The most popular ETF is the SPDR S&P 500 ETF which is passively managed and based on the S&P 500 index which includes primarily large cap stocks. The S&P 500 is considered a broad market index because it includes 500 different companies. The appeal of investing in a broad market index is that there is such diversity that gains and losses are averaged out across various kinds of stocks as to realize the overall returns of the market. 

But most funds are based on a much more narrow set of indexes which include various sectors, market caps, stock styles, or niche markets. These, more narrow indexes subject the investor to much higher risk. Therefore, you might think you are choosing an ETF in order to diversify, but you might actually be be putting your investments at risk by specializing. 

Let's take a closer look at ETFs and indexes.

The term ETF stands for Exchange Traded Fund. These funds are traded on the open market like a stock. But unlike a stock, which represents ownership in a single company, ETFs own a bundle of stocks for the purpose of gaining the returns of the average of all of the stocks owned within the ETF.

All ETFs are based on an index. An index is a list of stocks that have something in common. The S&P 500 is simply a list of the top 500 companies in the US. Other indexes might include all companies that are categorized within the energy or financial sector. Some indexes are even more narrow and might include only companies that mine gold. 

There are different types of ETFs and there are literally hundreds of indexes that an ETF can be based on. The three types of ETFs include:

1. Passively Managed - An ETF that mimics an index. As an example, if the ETF has the S&P 500 as its benchmark index, then the fund will include all of the stocks within the S&P 500 in an equally weighted manner. 

2. Enhanced Strategy - An ETF that mimics an index but where a manager will allocate a higher percentage of assets in specific stocks that the manager thinks will improve the overall performance. For instance, if a company represents 1% of a group of companies within an index, but the manager thinks that that particular company will do better than others, then the manager is free to increase the ratio of holdings for that company and decrease the ratio for other companies. The fund still owns all the companies in the index, but at a different proportion than the actual index. 

3. Actively Managed - An ETF that has an index as a point of reference, but whose manager will invest in whatever set of stocks they think will produce the highest returns. In this case, the index may have 100 companies included, but the manager believes only 20 of those companies will produce good returns so he only includes those 20 in the fund. His stock picks were limited by the index, but did not have to mirror the index in any meaningful way other than those companies invested in were a subset of the index.

Now let's take a look at the indexes themselves. There are three strata of indexes:

1. Broad Market Index - This include indexes based on the S&P 500 or Dow Jones or Nasdaq which theoretically include companies from all market caps and sectors.

2. Sector Index - This is based on a single sector such as energy, utilities, or financials.

3. Niche index - This is the smallest grouping and would include a small subset of the sector market such as a wind energy subset of the utilities sector.

For further understanding, take the utility sector as an example. Out of 18 utility ETFs listed on Fidelity's website there are 18 different benchmark indexes. There are multiple indexes for clean energy, solar energy, wind energy, technical leaders, or renewable energy. There is a global 1200 utilities index, an AlphaDEX index, a Uranium and Nuclear index, a China utilities index, and a dimensional utilities index. How is one supposed to determine which one to invest in when there is so much diversity on the definition of what a utility is?

The point of owning a utilities index would be to gain the overall return from all utilities. Know this: the smaller and more narrow the index, the greater risk that you will not realize the average returns you might think you are getting. 

If you think wind energy is going to produce big returns in the coming years, then you may want invest in that niche area by investing in a wind energy ETF. But then, which of the wind energy benchmark indexes? You can quickly go down the rabbit hole. 

To make things more confusing, once you start combining the types of ETFs with the various benchmark indexes you can end up with almost unlimited risk and loss of capital which is exactly what you are trying to avoid.

 For instance, the First Trust Utilities AlphaDEX Fund is an enhanced strategy ETF based on its own StrataQuant Utilities AlphaDEX Index. Essentially, it created its own index of stocks that it believes a utility index should include and then (because it is an enhanced strategy ETF) it can then largely ignore it's own index to invest disproportionately in the stocks it believes will produce the highest returns. And what is the five year return for this fund? 6.91%. Terrible.

If the whole point of ETFs and indexes is to reduce risk, how should we view all of these options? Use the table below. 

The safest kind of ETF is one that is based on a broad market index and is passively managed. An example of this would be the SPDR fund which tracks the broad market index of the S&P 500. You would expect a return close to the overall market return with this fund. 

On the opposite side of the spectrum, the riskiest kind of ETF would be one based on a niche index that is actively managed. Since this area is riskier, you would expect some ETFs to have very impressive returns and some ETFs to have losses. 

For instance, the Infracap MLP fund tracks the Solactive MLP & Energy Infrastructure index and is actively managed. This fund provided an average yearly return over the last five years of -24.49%. This means you would have lost almost 25% of your fund every year for five years. If you started with $10,000, then after five years you would only have $2,373 left.

On the other hand, the ARK WEB X.0 fund tracks the MSCI USA IMI Information Technology index and is also actively managed. This fund provided a return over the last five years of 42.01% per year. For this fund, and initial investment of $10,000 would have turned into $57,735. 

The greater the risk, the greater the potential rewards or losses. The more moderate the risk, the safer the return.

To be fair, there are some very good actively manged ETFs based on niche indexes. But no matter how well managed the fund is, if that sector and niche experiences deep losses like the energy sector is right now, there is nothing a good portfolio manager can do. That is the benefit of a passively managed, broad market index ETF. When some sectors go south, others are doing well, averaging out the good and bad. 

Here are a few recommendations. 

1. If you are very risk averse, stick with passively managed, broad market index funds like SPDR which tracks the S&P 500.

2. If you want to invest in a specific sector, choose a passively managed fund that is based on the entire sector. Look for benchmark indexes based on MSCI, S&P and Dow Jones sector indexes. An example would be the Vanguard Utilities ETF which is a passively managed fund based on the MSCI US Investable Market Utilities index. This index includes all utility stocks within the US and is a true sector index.

3. If you want to add some risk with the potential for greater returns into your portfolio, be prepared to do some research first. Before choosing an actively managed or enhanced strategy fund, find a sector fund that is based on the overall sector index. (My personal favorite are sector ETFs based on MSCI sector indexes.) Use that sector fund as a baseline for comparing the returns of the risky ETF you are considering. Reject any enhanced strategy, actively manage, or niche index funds that have a return lower than the overall sector. Then rank the remaining funds based on their three, five, and ten year returns (if available). Only pick from those funds whose returns are in the top 10% for all three yearly returns. This removes any funds that are ranked high due to a single high-return year. And finally, once you find an ETF you think you really like, go read everything about the fund: who they invest in, why their ETF is poised for good growth, whether they manage other successful funds. When you are completely comfortable, then and only then, invest a reasonable amount of your portfolio. Don't take a big gamble, especially on a single, risky ETF.

ETFs are great ways to make investments. But if you want to get the best returns, make sure you understand what you are investing in and make sure you understand the risks involved.