HOW TO EVALUATE ETFs

 



(Mostly) updated for February 2017

I’ll be using this ETF as an example: FTSE Canada All Cap Index ETF (VCN). It tracks the general stock market behavior of Canada, thus buying it sort of means you are buying the whole country. Remember from my other post that ETFs and mutual funds are both packages that hold multiple stocks within. Buying one share of an ETF is like buying all the stocks within it. You only really need to know a few things about them:

 

1. Management Expense Ratio (MER)

 

Like any product, a company won’t bother selling it if they can’t make a profit. The MER is how they make that profit. The total value of all shares in an ETF is called the market cap, and the ETF provider(Vanguard in our example) earns money by taking a small percentage of the total market cap. By charging a percentage rather than a flat fee per share they eliminate fluctuations that would arise from the fund changing in value as it’s bought and sold.

The MER covers all expenses related to the fund. Fund expenses include paying management, market fees, transaction fees, and company overhead. Mutual funds have to pay a manager to actively trade throughout the year, but ETFs have no such manager, and thus have one less expense. The savings are passed onto you in the form of a massively smaller MER!

Ok ok but what makes a good MER? I believe that under 0.5% is good, and under 0.1% is great. Lower is almost always better considering how small reductions in fees can mean many thousands of dollars over a lifetime. Luckily the best products with the most diversification are also the cheapest, like our VCN that supplies most of Canada for a mere 0.06% fee.

Sometimes a fund has multiple fees like the 0.05% management fee shown above. Don’t worry, you only need to know the MER, which combines all the the random fees into a total. In our example, VCN’s market cap is $264.4 million, of which Vanguard will take about $15,864,000 per year with the 0.06% MER. Seems like a lot for them to be earning in fees but for you, dear investor, you’ll only lose $6 per year on a $10,000 investment. Not to mention the average yearly return of 7%, or $700.

 

2. Total Returns

 

 

 

The total return is the percentage that your investment will rise or fall in a given time period. The normal timeframes to report are the Year-To-Date (YTD), 1 month, 3 month, 1 year, 3 year, 5 year, 10 year, and return since inception (i.e. total return since the fund was created). In the example above there are three rows:

  • Market price – the return based on the exact price you’d pay on the stock market
  • Net Asset Value (NAV) – the market price minus the fund liabilities. NAV is a fairly complex thing and for your purposes it’s irrelevant.
  • Benchmark – the expected return if you owned all the fund’s holdings directly instead of through the ETF. Theoretically if the ETF had no fees it should follow the benchmark exactly.

VCN is a relatively new ETF with an inception date in February 2013 making it 4 years old so the 5 year return is blank (such a cute little toddler ETF!). Had the ETF existed five years ago it would have roughly matched the benchmark and returned 7.3%. Therefore you can used the benchmark to estimate historic returns for new ETF products. And ETFs are all the rage right now so you better believe there will be many new ones coming.

Fun tip – Go to the performance tab on any ETF page, change the display to cumulative. and look at those juicy multi-year returns! As of this writing the benchmark returned 34% over 3 years. Had the fund existed and you had put $10,000 in, you would have roughly $13,400 today.

 

3. Sector Weighting

 

 

 

Sector weighting tells you what industries the fund invests in. VCN holds 37% in Financials, and 18.8% in Oil & Gas, and a bunch of other crap. As you can see the Canadian economy is mostly banks and oil sands. When you are buying multiple ETFs you’ll want to consider the sector weighting so you aren’t too invested in any one sector. Diversification people come on!

 

4. Top Country Exposure

Kinda self explanatory. VCN is 100% Canada. You can’t only invest in one country! You’ll need an international ETF to be properly diversified. I got a good one picked out for you: FTSE Developed All Cap ex North America Index ETF (VIU), lets use it from now on:

 

Lots of different countries here! VDU holds stock in 22 different countries. If you buy multiple international ETFs (which you shouldn’t for simplicity) make sure you aren’t too heavily invested in any one (except Canada because you get tax savings).

The ratio of country holdings is based roughly on the size of their economies and stability of the country. USA has the largest and you might as well get an ETF just for them. China is the second largest but they can be unstable and aren’t normally included. Japan is third, and has a stable economy, so they make up the largest portion of VIU above. Germany, UK, and France are fairly close and thus they make the next three.

 


 

Now you know the basics of ETF evaluation. If you’ve read up to this point I’m sure you’ll browse around some of the ETF profiles. ETFs are exploding in popularity these days and many investment companies are jumping on the bandwagon:

  • Vanguard has their V line
  • Blackrock has their iShares line
  • BMO has their BMO line
  • Horizon has their H line (side note, Horizon sells Swap ETFs which are a little different, read more here before you go buying them)

There is no “best” ETF or ETF company, it depends on you as an individual. Some ETFs pay dividends, some are very specific like US healthcare, and some target specific regions like all of Europe. As long as you invest SOMEWHERE instead of NOWHERE the differences will be marginal. Still interested in mutual funds? Click Here to be taken to my page comparing mutual funds to equivalent ETFs.



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 Posted by at 8:45 am

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