One thousand six hundred and seventy-four exchange-traded funds are vying for your dollars. Don't throw up your hands at the absurd complexity of it all. Just a few dozen of these funds are worth your attention.
The essence of ETF selection is finding what's cheap in whatever category your money is aimed at. You want broad exposure to domestic stocks? Then Charles Schwab & Co. has the top-scoring fund, a product that costs a $10,000 saver only $23 over a decade. Foreign stocks? Vanguard has a fund with a $24 price tag. High-grade U.S. bonds? Schwab and Vanguard have the cheapest entrées to the market, but an iShares fund from BlackRock is close behind.
Savers can be thankful for the price war in the $2.2 trillion U.S. ETF business. The big, established players will get into battles over a basis point--that being $1 of annual fees on a $10,000 account. Fidelity, a latecomer, has a lineup of sector funds (health care, energy and others) on which it just slashed the fee from 12 basis points to 8.4. More than a few exchange-traded funds have, by dint of some extracurricular income, gotten their net costs down into negative territory.
Note what is not relevant to our Best ETF rankings. We pay no mind to who's managing the fund or what its past performance was. Why? The vast majority of ETF assets are passively managed. The funds, that is, are mechanical collections of stocks or bonds preassigned to some index. You're not buying an international fund or an inflation-proof bond fund because it did well last year. You're buying it because you need more of that category in your portfolio.
So your focus should be on cost factors--three of them.
The biggest is the expense ratio, the percentage of assets taken off the top every year to keep the doors open. Some ETFs shave 100 basis points or more. Schwab U.S. Broad Market (SCHB) charges 3.
Next is the trading cost, the amount lost to a marketmaker when you get in and out. If a $50 ETF share has a 3-cent spread between its bid and ask prices, and you're investing $50,000, you'll lose $30 (plus brokerage commissions) on every round-trip.
The third cost component is one you will almost never hear about, outside of this FORBES survey. It's the cost offset from securities lending. Fund operators lend out stocks (and, rarely, bonds) to short-sellers, collect a fee for their trouble and give some or all of the money back to shareholders in the fund.
This is a big deal. BlackRock delivers $340 million a year of the booty to its ETF investors. At some small-company funds the lending income is more than enough to cover the expense ratio, meaning that the fund operators are in effect paying you to let them manage your money.
You couldn't do as well with a do-it-yourself portfolio. The reason is that small investors don't have the clout to get any stock-lending revenue. The broker pockets the money.
Add up the three components and you get the cost score featured in the Best ETFs survey. Our rankings cover 13 categories, from large-cap stocks to muni bonds. A directory of links to those rankings is at the end of this story.
The sources for the raw data behind our calculations were Morningstar (most of the inputs), Bloomberg (bid/ask quotes captured over four days) and fund vendors (securities-lending income).
Settling on a category and knowing which funds deliver it best is a starting point. Now contemplate these five principles of smart ETF management.
Robert Babboni For Forbes
Beware exotic flavors. The point of passive investing is to buy a little of everything, in proportion to market capitalizations. That's too boring for some fund operators, who have concocted a slew of "smart beta" and "low volatility" funds to feed investors' yearning to beat the market. They are selling passive investing with a special sauce. Their fees are high.
Some of these strategies would have done well in certain periods in the past. Can you expect a repeat performance? If your smart-beta stocks are destined to beat the market, who is making you rich by owning dumb-beta stocks?
Compare the mutual fund. The important market indexes, like the S&P 500, are available in both ETF and mutual fund versions. With mutual funds you are buying and selling from the fund operator, and if the fund is no-load you buy and sell at net asset value. There's no transaction cost.
With an ETF, in contrast, you are buying from and selling to a marketmaker. You lose the spread between what the middlemen are willing to pay when buying and what they charge when selling.
Short-term investors, then, are better off playing with mutual funds, at least if they can dodge any rules (or penalty fees) designed to curb speculation. They foist the cost of in-and-out investing on fellow shareholders.
Long-term investors are better off in ETFs. Since ETFs do not have to buy and sell stocks to meet purchase and redemption orders, their portfolios should do slightly better over time.
ETF investors also have a tax advantage if they are investing outside a retirement account: They avoid unwanted capital gain distributions.
Consider the commission. We don't include commissions in our cost calculations because they vary from broker to broker and are often zero. But you should be aware of them. They can make small trades in ETFs uneconomic.
Before jumping on a commission-free ETF trading offer, make sure it isn't steering you into an expensive fund.
Time your trading. The best time to go into or out of an ETF is between 3 p.m. and 4 p.m., says Gary Gastineau, who is a consultant to the industry. Liquidity is better in the busy hour. A review of 1,380 quotes on Bloomberg bears out his theory: We found average spreads to be twice as wide in the middle of the day (14 cents versus 7 cents).
You don't have to worry about timing for a fund that has 16 million shares a day of volume and shows a one-penny bid/ask spread, like Vanguard FTSE Emerging Markets (VWO). Timing does matter for a sleepy fund.
Avoid crowded trades. Someone who buys an ETF when most investors are buying, or sells when they are selling, is going to incur a transaction cost well above the slim bid/ask spread showing on a computer screen. When there's net selling, Gastineau explains, the marketmakers lower their bids to below net asset value. That's because they have to unload these unwanted shares by redeeming them in kind. They wind up with shares of the portfolio companies that then have to be sold. All this activity is risky and expensive. The reverse is true when there's a flood of buy orders for an ETF.
How do you know what the crowd is doing? Professionals can see order flow on their quote machines. Amateurs can get a sense of what is going on by looking at the "intraday indicative value," which is an estimate of a fund's net asset value. You'd get the number for that Vanguard Emerging fund by typing ^VWO-IV into Yahoo.
If the indicative value is above both bid and ask, there is probably a lot of selling under way. That's a time to be a buyer. Do your selling, if you can, when prices are floating above indicative value.
Best ETFs: Large-cap
Best ETFs: Small- and Mid-Cap
Best ETFs: Sector Funds
Best ETFs: Diversified International
Best ETFs: Specialized International
Best ETFs: Currency and Commodity
Best ETFs: Short-term Bonds
Best ETFs: Medium-term Bonds
Best ETFs: Long-term Bonds
Best ETFs: Inflation-proof Bonds
Best ETFs: Municipal Bonds
Best ETFs: International Bonds
Best ETFs: Stock and Bond Mixes
