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Guide to Picking and Comparing ETFs

A quick rundown of the factors to consider when choosing between two comparable ETFs
By John Gabriel, ETF strategist with Morningstar, responsible for Canadian ETF research.

A little bit of due diligence can save you a lot of headaches when it comes to investing in ETFs. In any given market segment, it is not uncommon to find two or more similar ETFs from different providers or fund families. And as ETF industry growth and product proliferation continues, the number of similar (or similarly named) products is bound to grow.

That's all the more reason to dust off your investing toolkit and learn how to do some ETF comparison shopping. Below, we've listed some key differentiators that an investor should keep in mind when comparing two similar ETFs dedicated to the same market segment.

Management-expense ratio (MER)

The expense ratio is the most reliable predictor of future performance for investment funds, and ETFs are no exception–that is, cheap funds, on average, tend to be better performers than those that are more costly. And in many respects, ETFs and index funds are commodities; there's little differentiation, so you might as well go with the cheapest one.

For example, Claymore Gold Bullion (non-hedged) and iShares Gold Trust are two very similar ETFs that both hold physical gold bullion. But the iShares fund has a price tag of 0.25% compared with 0.50% for the Claymore fund. The large discrepancy in price, with no difference in exposure or risk/return characteristics, leads us to favour the iShares offering.

Index construction and underlying holdings

Two ETFs that focus on the same sector and have similar names can have radically different underlying holdings if the indexes they track are constructed differently. This, of course, means that the two ETFs will have different risk/return profiles. Taking a look under the hood of each ETF enables you to see what the fund owns, how it weights its holdings and how diversified (or undiversified) it is. Simply put, the nametag is not enough.

For example, BMO Global Infrastructure holds 50 stocks with about 63% of its assets concentrated in its top 10 holdings, while Claymore Global Infrastructure holds 60 with just 37% in its top 10 holdings. If you were trying to make your decision between the two ETFs solely based on the names, then you would have no way of knowing that the BMO fund tracks a market-capitalization weighted index, while the Claymore fund selects and weights its holdings based on a proprietary quantitative multi-factor selection process.

These different portfolio compositions caused an 11% gap between the returns produced by the two ETFs. Also, the Claymore ETF charges a 0.72% MER for its proprietary strategy, while the BMO ETF levies 0.55% to track a plain-vanilla index.

There's no need for concern if you find yourself starting to feel overwhelmed. In each of our ETF Analyst Reports we provide a detailed discussion on portfolio construction, including our take on how the ETF might fit into an asset-allocation framework as well as the risks it could introduce.

Commissions to buy and sell

As you compare and contrast various ETFs, also pay attention to what it will cost you to buy and sell them. These transaction charges will vary depending on your brokerage firm, so it is important to "read the fine print."

If you're a buy-and-hold investor who plans to invest a large sum and let it ride, then commissions shouldn't make a big difference to you. But if you trade frequently or wish to employ a dollar-cost-averaging approach by investing small sums of money regularly over a long period, broker fees can quickly rack up and eat into your returns.

To overcome that obstacle, Claymore Investments, Inc. pioneered a series of investment plan options through an agreement with several Canadian broker/dealer firms. The Pre-Authorized Cash Contribution Plan (PACC) offered by the firm allows unitholders to invest on a regular basis (say monthly or quarterly) in one of the Claymore ETFs without worrying about trading commissions. This is designed so that investors can accumulate assets over a long horizon and take advantage of the benefits of dollar-cost-averaging.

Bid-ask spread

ETF investors should also mind bid-ask spreads. Such spreads aren't an issue for traditional index mutual funds; the price you pay is equal to the end-of-day net asset value. But ETFs, like stocks, trade intraday on exchanges, and buyers and sellers have to agree on the price. On an ETF's Morningstar Quicktake Report, the bid-ask spread data point shows you the highest price that a buyer is willing to pay for an ETF and the lowest price for which a seller is willing to sell it. The larger the difference between the two, the higher your costs will be to execute the trade.

The size of the spread gives you a sense of the liquidity of an ETF and its underlying holdings. ETFs with a lot of trading volume that also hold highly liquid securities will have very small bid-ask spreads. For example, the bid-ask spread of iShares S&P/TSX 60 is consistently just a penny. Less-liquid ETFs, meanwhile, can exhibit much higher bid-ask spreads–for example, Horizons AlphaPro Gartman ETF recently had a bid-ask spread of 1%.

The spread can either widen or tighten depending on the liquidity of the ETF's underlying holdings. Most ETFs have pretty slender bid-ask spreads. Even still, I'd recommend that–with the exception of the most liquid ETFs–investors always use limit orders to help ensure a fair execution price.

Premium/discount

An ETF's net asset value (NAV) is calculated by dividing the total value of the portfolio's securities by the numbers of its shares outstanding. On the other hand, the market price of an ETF–the price at which you actually buy and sell your shares–is determined by the forces of supply and demand, just as is the case for stocks. As a result, the market price of an ETF can deviate from its NAV. When the market price is higher than its NAV, the ETF is trading at a premium; that means you are paying more for an ETF than its holdings are actually worth. When an ETF's market price is lower than the NAV, it is trading at a discount, and you're buying the ETF for less than the value of its holdings.

Like the bid-ask spread, premiums and discounts are affected by the liquidity of the ETF's underlying holdings and trading volume. As, such, ETFs that traffic in highly liquid securities, such as domestic large-cap stocks or government bonds, tend to exhibit only small discounts and premiums. But the premium/discount numbers become more relevant in the realm of international equity, non-government bond, and commodity ETFs. These asset classes might trade at premiums or discounts because of supply/demand imbalances or other factors. This doesn't mean you should avoid these ETFs, as they might provide worthwhile diversification benefits. Moreover, premiums and discounts often self-correct, so what appears to be a high premium today might not be there tomorrow.