Yahoo Finance How to Choose Large-Cap ETFs to Anchor an Investment Portfolio
When building a portfolio, finding securities that fit one's risk-reward profile can be challenging, considering the thousands of equities from which to choose. And even after simplifying the selection process by turning to exchange-traded funds to anchor a portfolio, investors can still be intimidated by hundreds of available funds.
But how should investors narrow the list down to find the best portfolio candidates in the large-capitalization arena -- a sector that offers dozens of possibilities?
"First, decide whether you want an actively managed ETF or a traditionally passive one," says Derek Peterson, a former vice president at Morgan Stanley in Irvine, California. "Active ETFs allow the manager to hedge risk and make intraday trades to attempt to outperform the benchmark. Traditional ETFs are passive and only change when there is an allocation shift in the associated benchmark. By choosing an active ETF, there is an additional risk of underperforming the market, and internal fees are generally higher."
Matthew Tuttle manages the Tuttle Tactical Management U.S. Core ETF (TUTT), an actively managed tactical ETF able to switch from 100 percent stocks to 100 percent bonds to 100 percent cash as the situation dictates. He also suggests focusing on smart beta large-cap ETFs.
"Most ETFs follow market capitalization-weighted indices that weight stocks by size, regardless of how attractive the company is," Tuttle says. "Smart beta ETFs weigh companies by fundamental factors. It may be valuation, earnings growth, dividends, volatility or others. Over time, these ETFs have done better than their market-cap-weighted brethren."
While most investors might grab the subset strategies of value and growth with the large-cap ETF space, some experts suggest broadening out to a different arena.
Ron Weiner, founder, president and CEO of RDM Financial Group in Westport, Connecticut, has chosen the EGShares Emerging Market Consumer ETF (ECON), which is "strictly focused on consumer spending increases in emerging [markets]. This is a case where we can hone in on very specific areas of the global market place via ETFs," he says.
J.J. Feldman, portfolio manager at Miracle Mile Advisors in Los Angeles, suggests using a minimum volatility ETF, such as the iShares MSCI USA Minimum Volatility Index (USMV), which owns 164 names within the Standard & Poor's 500 index and "focuses on companies with lower standard deviations without overweighting a sector."
Many investors often look to performance as the only criteria upon which to select an ETF investment. What they may forget, however, is the risk associated with that ETF that earned its outperformance.
One tool for investors is the Sharpe ratio, which tracks performance in relation to the rate of return on a risk-free investment like U.S. Treasury bonds or bills. The higher the Sharpe ratio, the better the return as compared to a risk-free investment approach. For instance, the Guggenheim S&P 500 Pure Growth ETF (RPG) has a five-year return of 148 percent with one of the highest Sharpe ratios (1.38). Its expense ratio was 0.35 percent, or $35 annually per $10,000 invested -- slightly lower than the sector average.
Another promising fund is the WisdomTree LargeCap Dividend ETF (DLN), with a five-year return of 100 percent and a below-average expense ratio of 0.28 percent. It has a Sharpe ratio of 1.50, one of the highest in its category. The iShares MSCI USA Minimum Volatility Index (USMV) sports a three-year return of 14.93 percent and a Sharpe ratio of 1.73. Its expense ratio is a bargain-basement 0.15 percent.
Investors should also keep an ETF's expense ratio in mind, financial advisors say. Back when mutual funds were the only aggregation game in town, the expense ratio was frequently mentioned in finance literature as being a critical element when making choices among funds. It's easier to forget that ETFs have expense ratios because ETFs trade just like stocks -- and some investors may think their brokerage trade commission is the only expense associated with holding an ETF.
"Ten basis points would be considered on the low side, so I would recommend starting there and determine what added value you are gaining for any expense premium to that for both passive and actively managed ETFs," Paterson says. "If a fund has a history of outperforming the market by 1 percent and the additional fee for that fund is 0.2 percent, then it may be worth it if your risk tolerance is in line with the fund's objective."
Kevin Barr, head of the investment management unit of SEI Investments in Oaks, Pennsylvania, says choosing an ETF depends on the objective of an investor's portfolio. "Liquidity and cost are two of the major considerations. Generally, ETF investors are looking for low-cost, passive or quasi-passive exposures to asset classes, so it's important that the fund be affordable while still offering exposure that's consistent with the desired asset class and style. And liquidity matters quite a bit -- many investors choose ETFs over open-end mutual funds for their intraday liquidity, so it's important to choose ETFs that allow for efficient position entry and exit without adverse price impacts," he says.
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