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4 Ways to Find Best in Class ETFs

4 Ways to Find "Best in Class" ETFs
July 9, 2009

SAN DIEGO (ETFguide.com) – Today more than 40% of the ETF/ETN marketplace is littered with obscure funds with less than $100 million in assets. As Napoleon Bonaparte once said, “Glory is fleeting, but obscurity is forever.”

If you’ve invested in ETFs or ETNs with less than $100 million in assets, obscurity may blindside you. Maybe it won’t. How can you sort through the financial clutter?

Here’s four key parameters that we use at ETFguide.com that can help you to identify “Best in Class” ETFs.

Fund Fees and Costs
While it’s generally correct to favor ETFs with the lowest expense ratios in their respective category, don’t overlook the trading cost reflected in the bid/ask spreads of these funds.

For example, the Claymore/BNY Mellon BRIC ETF (NYSEArca: EEB), iShares MSCI BRIC Index Fund (NYSEArca: BKF), SPDR S&P BRIC 40 ETF (NYSEArca: BIK) all have the same general investment objective. Each of these funds is focused on stocks concentrated in four mega-emerging market countries: Brazil, China, India and Russia.

The annual expense ratios for these funds range from 0.75% for BKF to 0.60% for EEB all the way to 0.50% for BIK. Which fund do you choose? Before you answer, a quick look at the bid/ask spreads tells you which ETF has the most economical trading cost.

According to Morningstar data, EEB’s bid/ask spreads today are just 0.13% compared to 0.21% for BIK and 0.27% for BKF. Even though EEB doesn’t have the lowest expense ratio of BRIC funds, its aggregate cost (fund expense ratio + bid/ask trading cost) seem to be the most favorable in the group. The cost of bid/ask spreads are variable, so be sure to check them periodically.

Generally, ETFs with higher trading volume tend to have tighter or lower bid/ask spreads. This results in smaller frictional cost for buying or selling your ETFs compared to funds with lighter trading volume. Do not make the mistake of overlooking the bid/ask spread cost of the ETFs you invest in. 

Correct Product Structure
Exchange-traded vehicles have five basic product structures: Open-end fund, unit investment trust, grantor trust, limited partnership and exchange-traded note (ETN). We believe avoiding the product types with fatal structural flaws will contribute greatly to your investment success.

To that end, we've consistently warned our subscribers about the systematic dangers of ETNs. They are wrought with credit default risk along with taxation risk. No matter how sound or safe that sponsoring institutions try to make ETNs appear, they pose significant financial risks to their owners. These risks, it should be noted, are unlike market risks, because they're totally avoidable.

As such, it’s our view that "Best in Class" ETFs use product structures that are advantageous to the investor from multiple angles including, investment, credit and a taxation perspective.

Index Transparency
The progression of ETFs first began with traditional market capitalization weighted indexes that offer unfettered transparency. Today, that progression has unfortunately devolved.

The exact strategy for how an ETF index is selecting and weighting securities, in some instances, is not made clear to investors in fund prospectuses nor in marketing materials. For example, the PowerShares Dynamic ETF Portfolios do not reveal the exact methodology for how stocks within them are being selected. The selection methodology, we're told, is "Proprietary." This offers ETF investors little insight and zero transparency.

We believe "Best in Class" ETFs should offer 100% transparency about the true selection and weighting methodologies for the securities within them. To that end, ETFguide.com's free online database uses a financial tool called "Index Strategy Boxes", which visually map the true indexing strategies of both ETFs and ETNs.

Based upon our research, “Best in Class” ETFs consistently fall into the passive selection and market cap weighted category. This indexing method applies to stock, bond and commodity funds.

Delivering Market Exposure
Wall Street’s wonderful promises of market beating performance, also known as “alpha,” more times than not, turns out to be “alfalfa.” This is true of active management and it’s also true of nouveau indexing strategies that attempt to beat traditional benchmark indexes.

"Best in Class" ETFs should give you true representation to the asset class they propose to follow. This would automatically eliminate all ETFs and ETNs that follow fundamental and quantitatively oriented investment strategies because these products aren't attempting to match asset class benchmarks, but beat them.

While the idea of beating benchmarks is a noble cause, pure asset class exposure is far more noble, not to mention consistently more profitable.

What are the Best in Class ETFs for 2009?
To identify “Best in Class” ETFs we suggest using the following parameters outlined above. To review, here’s what they are again:  1) Funds that have the lowest fees/costs in their corresponding category, 2) Funds that have 100% index transparency, 3) Funds that offer true and pure exposure to the asset class they propose to track, and 4) Funds that use a product structure that minimizes taxes and credit risk.

In the July issue of the ETF Profit Strategy Newsletter, we identified a short list of “Best in Class” ETFs for 2009 – funds that meet our strict and discriminating criteria. We evaluated ETFs in key categories from commodities and stocks all the way to bonds.

And here’s what it means for you: Knowing which ETFs are “Best in Class” can help you to construct your portfolio on the right foundation. Stability finds investors that have a solid foundation.

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