Be critical in this ETF love affair

"Know what you own, and know why you own it."
Peter Lynch

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Everything about the other person is perfect in the first few weeks of dating. Short of kicking puppies, there is pretty much nothing your new person can do wrong. Even habits that you already know will annoy you one day are temporarily adorable. But just like a new relationship, most investors don't care about the details of what they invest in and don't try to find out more. Although ETFs aren't exactly new to the market, growth in the industry has been astronomical over the last few years. As everyone fawns over ETFs and jumps on the bandwagon, it's important to take the love goggles off and make sure you know what you're buying.

The first ETF was launched in 1993. In 2009, assets topped $1 trillion; this year they hit $4 trillion. This has, on the whole, been a boon for investors, who have benefitted from the lower cost of ETFs and performance of passive investing (which we know almost always outperforms over the long-run) versus active funds. We love low cost investing, but there are some things to look out for when making decisions around ETFs.

ETFs' tracking error against their benchmark

ETFs, for the most part, are passive instruments that track the returns of a benchmark index rather than trying to beat the market. Many investors are surprised to learn that some ETFs do not exactly track the indices they were created to mimic. The higher the tracking error from its benchmark, the less the ETF can be used to represent it. The ETF issuer can try to reduce tracking error, but this can potentially add expenses, which are typically passed on as a higher management fee to investors. You can't assume that two ETFs that track the same benchmark will perform identically or cost the same amount.

ETFs might be synthetic, which leads to greater risks

Sometimes, an ETF is just a wrapper. You need to dig deeper to see what the ETF is actually invested in. For example, United States Oil Fund (USO) is one of the more popular commodity ETFs. What investors don't realize is that the ETF invests only in oil futures, and doesn't directly track the performance of oil's spot price.

By owning swaps or futures that replicate the performance of oil prices or the index, you are inevitably exposed to counterparty risk (the risk that the other party taking the other side of the investment obligation defaults), and the potential higher costs associated with it.

The SGX have many synthetic ETFs and you can identify them by the "X@" beside the ETF's trading name.

All-in costs of ETFs

Similar ETFs from different providers, or even the same provider, have highly variable expense ratios (the cost of the ETF, which is taken out of the ETF price every day). Take for example Blackrock's emerging market ETFs IEMG (iShares Core MSCI EM ETF) and EEM (iShares MSCI EM ETF): their expense ratios are 0.14% and 0.72% respectively. That is a huge spread for very similar exposure.

There are also other costs involved in executing an ETF portfolio strategy such as brokerage fees and bid-ask spreads when trading. Another lesser-known fact: sometimes, ETF issuers generate income by lending out their underlying securities to hedge funds to enable short sales. This does result in lower management fees, but also increases the risk for you.

Bid-ask spread as a cost is extremely important for Singaporean investors especially when considering SGX ETFs like S27 (SPDR S&P 500 ETF) which has a bigger bid-ask with a very low trading volume (~200+ shares per trading day)

Take the rose-tinted glasses off.

The myth that ETFs are always cheaper than unit trusts (mutual funds) is false. There are unit trusts (mutual funds) providers such as Vanguard and Dimensional Fund Advisors that have management fees in-line with or below ETFs for similar and even better implemented exposure. The most important thing to remember is to research the costs of ETFs/unit trusts before you invest, so that you make decisions that align with and will bring you closer to your financial goals. Alternatively, you can always let a trusted advisor do the work for you.