Credit: Shutterstock photoWith the ever expanding list of exchange-traded funds and exchange-traded notes becoming saturated with new strategies, investors in these funds must become more discerning in their structural analysis. While index construction, fees, and performance are key variables, many times important vital signs for the overall health of an ETF are easily overlooked.
The most well-known ETFs such as the Vanguard Total Stock Market ETF (VTI), iShares MSCI EAFE ETF (EFA), and SPDR Gold Shares (GLD) trade millions of shares per day and have many billions of assets under management. These bastions of the fund world are easily purchased to acquire exposure to a specific, diversified segment of the market through a low-cost investment vehicle.
It may sound simplistic, but when you are straying away from the largest and most liquid ETFs to capture a niche industry theme or index strategy, it pays to know ahead of time whether the vehicle is functionally sound. The more important aspects of this analysis include assets under management, average volume, length of time in existence, and strength of the fund provider.
Ron Rowland of Invest With An Edge publishes a monthly list of funds that he affectionately calls the ETF Death Watch. This includes ETFs and ETNs with less than $25 million in total assets and average daily dollar trading volume of less than $100,000 for an entire month. In addition, funds must have greater than six months of trading history to make the list. This allows for an incubation period for new ETFs that were just released to pick up steam.
The most recent September list indicated 330 funds are currently on the death watch for their lack of investor interest, which means they could potentially be shuttered at any time. That represents approximately 20% of the total universe of 1,643 exchange-traded products currently in existence. To put it another way, 1 in 5 ETFs fall under this viability threshold.
In my experience, the $25 million asset threshold is a good indicator of financial stability because it generally means that the fund can meet or exceed its underlying expenses. ETFs require ongoing overhead that includes: maintenance, legal, regulatory, licensing, marketing, and other hard costs. If they bleed money for an extended length of time, the fund provider is likely to consider closing the fund to shore up costs or cut their losses.
The only reason a fund provider would keep an ETF in existence despite these concerns is that they have a large enough stable of profitable funds to offset those costs. In addition, it may be a strategic move by the fund provider to keep a niche strategy in place for when the timing is right to see a wave of inflows based on performance or sentiment. Bigger ETF providers typically have more flexibility in this arena because they have more financial stability.
Another key indicator that should certainly be considered is trading volume. ETFs are designed to be liquid and transparent investment vehicles. If they aren’t efficiently creating liquidity through regular transactions, they are going to be problematic when it comes time to buy or sell. The use of limit orders can help alleviate any trading irregularities that may crop up as a result of a thinly traded ETF.
However, funds with extremely meek or irregular volume should be avoided to avoid serious pricing concerns. I have seen extreme cases of ETFs going weeks without trading a single share, which will then price subsequent trades with wide gaps in between based on the change in net asset value. The average investor will likely want to steer clear of any ETF with average daily volume less than 25,000 shares. That data, along with assets under management, is readily attainable at nearly every major finance website.
Paying careful attention to these data points can help alleviate the concern that an underperforming ETF in your portfolio will be shuttered due to lack of participation. If you do come across an ETF with these characteristics, there may be a competitive offering with better volume or assets as a worthy substitute. In addition, it may make more sense to purchase individual securities in a specific niche rather than a diversified basket of stocks with a lack of involvement.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
