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In this post, let’s talk how to research ETFs to maximize your investment returns and wealth. With thousands of funds on the market, sometimes it is hard to pick the right one. Today, I will share my thought process and the resources I use to do my ETF due diligence.
1. Keep An Eye On ETF Fees
The first and one of the most important items on the list is fees. According to John Bogle, the founder of the Vanguard Group, higher fees can signal lower returns.
Thanks to the Vanguard Group and John Bogle, fund fees have been going down. According to Morningstar, the average expense ratio fell by over 2x over the last 20 years (from 0.83% to 0.34%). Investors have saved billions in fund fees.
Still, there are many funds out there charging 1% or more. Compare this to an average of 0.07% for Vanguard’s funds. Even 0.30% or 0.50% may not seem much. But, it can snowball into something big.
Why do fees matter? Let’s take a look at an example. Suppose that you can reduce your expense ratio by 1%. Over a lifetime of saving and investing, extra 1% can extend your retirement by up to 10 years according to Bogleheads analysis.
1.1. Hidden Portfolio Turnover Costs
Here is another set of fees hiding in plain sight. And, those are trading costs from portfolio turnover. It loosely signals the percent of investments that an ETF changed in the last year. Turning over holdings comes with trading costs for a fund. These costs are separate from an ETF’s expense ratio.
For a passive index fund like S&P 500 or Nasdaq-100, portfolio turnover is usually under 20% – 30%. But, for active funds or ETFs that have to replace holdings often, it could be way more. For instance, take SPMO, which is a momentum passive index fund. Given its rules, it has to trade and replace its stocks often. SPMO’s turnover was 72%. This signals that this fund probably incurs a lot of trading costs.
Of course, if an expensive fund generated total returns above its peers, it may not matter. Still, it is a metric any risk- and cost-conscious investor should be aware of.
2. Pay Attention to ETF Portfolio Construction
The second key thing to focus on is how a given ETF constructs its portfolio. Portfolio construction can tell a lot about ETFs’ future performance. Let me give you a concrete example of how I do this.
2.1. FNDF ETF Construction Example
Let’s take an international fund called FNDF by Schwab. The first thing I start with is going to a website and reading what’s available. The first thing to note is the ETF’s focus on developed markets only. Schwab says that the fund uses fundamentals to weight its holdings. Now, this piques my interest. Most ETFs weight their holdings by market capitalization.
Next, let’s look at the fund’s prospectus. Here we get more details with the underlying index for the fund.
It looks like the fund uses companies’ sales, cash flows and payouts to weight its holdings. This allows the fund to take a more contrarian approach to investing.
But, let’s find info for the underlying RAFI index. We see that the index provider gives way more details.
It says that market cap weighted indices can overweight overvalued companies. Again, we see that this index uses sales, profitability and payouts to weight its holdings.
If we think about market capitalization, it fluctuates a lot, right? It could be due to some one-off event or a shock that will disappear tomorrow. While stock price whipsaws, company’s fundamentals can be a more stable yardstick. Now, this is a bold statement. If this were true, why don’t other ETFs do that? Is there research that gives credibility to these claims?
The RAFI website mentions a research paper “Fundamental Indexation.” 2005. Arnott, Hsu, and Moore that this index provider used as a basis. This paper got published in a peer reviewed Financial Analyst Journal publication. You don’t have to be an economist to understand the paper’s gist.
I usually read abstract, intro and conclusion sections. There is a lot of information that you can get from that. For instance, the main hypothesis of this paper is stock prices are too noisy to measure the true value of a company. Fundamentals are the way to go. If you tell that to Warren Buffett, he would laugh and say, ‘duh’.
The paper used fundamental metrics that differ somewhat from what FNDF uses for portfolio constrcution. Overall, the paper shows that their methodology produced better returns compared to the S&P 500.
Now, understanding the ETF construction can be a bit more involved like this. Or, it could be as simple as the QQQ fund that tracks Nasdaq-100. Either way, I spent a lot of time here. By reading on a fund’s literature, I learn a lot about an ETF and its potential future performance.
3. Reading ETF and Fund Research Reports
What I also do sometimes is read Morningstar fund reports. For that, you need a Morningstar subscription. I partnered up with Morningstar to bring $50 OFF to my readers for your first year subscription.
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4. Active vs Passive Index ETFs
All this works fine for passive index funds. But, what about active funds? Unfortunately, they look like black boxes from outside. You will have to have a lot of faith in the fund’s management. The majority of active funds underperform their benchmark for a reason. For instance, close to 90% of large-cap active funds have failed to beat the S&P 500 over the last 15 years.
Many active funds face management turnover problems. If a talented manager leaves, the outperforming fund may see its returns revert to the mean. Also, star managers may lose touch and their stock picks may turn out to be plain wrong. Take Cathie Woods and her ARKK active ETF. After years of massive returns, it is so beaten down that it did not even outperform the Nasdaq-100.
Or look at the ULTY ETF by YieldMax. Not only is the fund is very expensive at a 1.30% fee, bu, this ETF went through multiple changes in its investment strategy. It is as if YieldMax is conducting a live experiment with investors’ money. Again, faith plays a big role here.
Passive index funds have an advantage in this regard. They come with clear defined rules for portfolio construction. If they are right or wrong, you know where they are coming from. With active funds, you can have a vague or no idea.
5. Researching ETF Allocations and Concentrations
The next things I look at are allocations and concentrations at the portfolio level. I usually use Morningstar for that. If you understand an ETF’s construction, there should not be any major surprises here.
Let’s take a look at FDVV ETF as a point of comparison. FDVV is a dividend ETF that tries to balance growth with yield. It gives a lot of weight to tech stocks as we see here.
Morningstar provides comparison to an average in a given category. For instance, we see that FDVV allocates almost 12% more to the tech sector compared to its peers. Its 12% allocation to growth is material. If we compare FDVV to SCHD, SCHD allocates nothing to growth stocks. This signals that FDVV leans more on price appreciation for its total returns.
As for total returns comparison, I use the Seeking Alpha website. It is a great tool to research stocks and ETFs. I also partnered up with them. Use my affiliate sign-up link below and you will get a discount on your first year subscription.
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They have awesome charting tools and I use them all the time. With it, you can compare total returns and other things. Also, I use their dividend tab to see how a fund’s yield on cost and distribution growth performed. All of this can give you a lot of insight about dividend funds.
Another resource I use is the SEC fund search. Sometimes, you want to know how a given fund looked like in the past. The SEC lets your search for specific ETFs and mutual funds and look at their sector allocations and holdings on an annual basis.
6. Comparing ETF Total Returns
As for the volatility adjusted returns, I usually go for either Morningstar or Portfolio Visualizer. Morningstar provides up to 10-year risk-adjusted metrics like the Sharpe ratio and max drawdowns. Same with Portfolio Visualizer. The free version of Portfolio Visualizer gives risk-adjusted metrics up to 10 years.
Risk-adjusted metrics and drawdowns provide insight into how a given ETF performs under stress. When everything tanks, you’ll have an idea of what’s coming. Volatility and drawdowns are a very big concern for risk-averse investors. It is especially important in retirement.
But, I want to call out one thing. Volatility is not the same as investment risk. Investment risk is a probability of permanent capital loss. What if a given ETF like QQQ fluctuates a lot, but shows outsized total returns over the long haul? For someone who is in his or her prime working years and is far from retirement, volatility is of little concern. Total returns are what matters. That’s why many young investors opt for growth funds.
How to Research ETFs Takeaways
There are many ways to research ETFs. This is how I do it. Using a combination of research tools, I spend most of my time understanding how funds construct their portfolios. This is the most important part of ETF research. If I understand construction methodology well, the rest should not be too difficult to grasp.
How do you research ETFs and what other tools do you use for that? Let me know in the comments.