A Former ETF Head At Lehman On How To Choose The Best ETF

| October 9, 2017 | 0 Comments

trading systemThere is a massive price war going on in ETF-land. Issuers are falling over themselves in the race to the bottom in fees.

Clearly, they’re doing it because it works. For many investors, low fees were the main reason you are invested in ETFs.

I saw some funds the other day that had a .04% expense ratio. That’s four basis points, meaning that if you invest $10,000, you pay $4 in fees.

In order for the fund issuer to earn $4 million in fees, the ETF has to have… $10 billion in assets.

$4 million is not a lot of money. That is a lemonade stand. And attracting $10 billion in assets is no small feat—only a handful of ETFs have managed to do that. So anyone who issues an ETF with four basis points in fees is doing so at a loss.

That’s capitalism in 2017! Producers impale themselves, consumers win. Somehow these businesses are worth something.

I stand by what I said last week about high broker commissions being better for investor psychology, but you should ruthlessly exploit funds with low expense ratios. There’s no psychological benefit to a higher expense ratio, you’re just paying more.

But fees are not everything. In fact, fees are only one of many considerations when you’re choosing an ETF—and they’re far down the checklist.

How Do You Choose an ETF?

Listen carefully.

First, you have to answer the following question: What kind of ETF do you want? Debt or equity? Sector, currency, or commodity? Global or international?

Let’s say you want an energy ETF. Well, there are 28 of them. For time’s sake, we won’t consider all 28 here, but let’s look at the top five in terms of assets:

  • XLE, the Energy Select Sector SPDR Fund
  • VDE, the Vanguard Energy ETF
  • XOP, the SPDR S&P Oil & Gas Exploration & Production ETF
  • OIH, the VanEck Vectors Oil Services ETF
  • IYE, the iShares US Energy ETF

Let’s say you want a broad-based energy ETF. That rules out XOP and OIH, which are subsector funds.

The next step is to dig down into the holdings of the ETF, ­­to look how the stocks are weighted and how top-heavy or concentrated it is.

XLE Holdings
Company Name Index Weight
Exxon Mobil Corp. 22.1%
Chevron Corp. 17.3%
Schlumberger Ltd. 7.6%
ConocoPhillips 4.7%
EOG Resources Inc. 4.4%
Occidental Petroleum Corp. 3.9%
Phillips 66 3.1%
Kinder Morgan Inc. 3.1%
Halliburton Co. 3.1%
Valero Energy Corp. 2.7%
Source: SPDR
VDE Holdings
Company Name Index Weight
Exxon Mobil Corp. 22.4%
Chevron Corp. 15.1%
Schlumberger Ltd. 6.6%
ConocoPhillips 4.0%
EOG Resources Inc. 3.7%
Occidental Petroleum Corp. 3.4%
Phillips 66 2.9%
Kinder Morgan Inc. 2.9%
Halliburton Co. 2.5%
Valero Energy Corp. 2.3%
Source: Vanguard
IYE Holdings
Company Name Index Weight
Exxon Mobil Corp. 24.1%
Chevron Corp. 15.5%
Schlumberger Ltd. 6.7%
ConocoPhillips 4.1%
EOG Resources Inc. 3.8%
Occidental Petroleum Corp. 3.4%
Phillips 66 2.7%
Kinder Morgan Inc. 2.7%
Halliburton Co. 2.6%
Valero Energy Corp. 2.3%
Source: iShares

You can see there isn’t a lot of differentiation among these indices; you’re essentially getting the same basket with each of the ETFs.

So if you’re indifferent between the three, then look at the fees:

  • XLE: 0.14%
  • VDE: 0.10%
  • IYE: 0.44%

That basically rules out IYE. So now we’re down to deciding between XLE and VDE.

One thing a lot of people don’t consider: If you’re a customer of a full-service brokerage and you pay commissions on a cents-per-share basis, you want an ETF with a high dollar price per share in order to minimize commissions.

In this case, that would mean VDE ($91) over XLE ($66). But if you are a customer of a discount brokerage, it doesn’t really matter.

One final concern is liquidity—you can get into this thing, but can you get out? All of these funds are pretty liquid, so liquidity is not a concern here.

And that’s how you choose an ETF.

 

Note: This article was contributed to ValueWalk.com by Mauldin Economics.

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Category: ETFs

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The author of this article is a contributor to ValueWalk.com. ValueWalk is your everyday source of breaking and evergreen news on everything hedge funds and value investing.

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