We at Canal Capital Management are big believers in ETFs, otherwise known as Exchange Traded Funds, because of their salient characteristics: cheap, tax efficient, intra-day trading, index replicating, etc., But just like with any investment product, they are not all created equal. Due diligence is required when investing in any ETF. At our firm, we follow a disciplined process when vetting any investment, and ETFs are no exception. We apply the following test: Efficiency, Tradability & Fit. Efficiency looks at a fund’s costs, while Tradability assesses average daily trading volume, and Fit examines the securities the fund owns. Though it may sound corny, this mnemonic device describes a process by which we narrow down some 1,500 ETFs to a more manageable security universe of choices that will best fit our investment objectives.
As an example, take an investor that wants to find an ETF to best invest in the Utility Industry: he would find that there are about 15 funds that are in this sector. Choosing the right one is a daunting task given the overwhelming wealth of information out there. By applying E-T-F to the decision making process, an investor can narrow down his search for the ETF that is the best and most efficient representation of the Utilities Sector. Below we compare two “Utilities” ETFs:
While they both have Utilities in the name, the AlphaDex Fund is more expensive, trades thinly, and has a much smaller allocation to true Utilities. For example, of the “utility” stocks AlphaDex Fund owns 23% are actually Telecom stocks which are not power companies and typically pay their dividends by returning capital rather than from cash flow. The lower cost fund on the other hand owns some 98% in Utilities.
This is not an endorsement of one fund over the other and will not predict which will perform better. It simply shows how we examine what’s under the hood, before investing for our clients so we can avoid the possibility of unpleasant surprises. The transparency of ETFs is yet another reason why we like them. OR… prefer them to mutual funds.