An expert's best advice for investing in ETFs

Globe Investor Magazine Online, Nov. 21, 2007
By HELEN BURNETT

Exchange traded funds are now available to Canadian investors in almost every asset class, with 18 new ETFs listed on the Toronto Stock Exchange this year alone, bringing the number to 47. This is in addition to the 560 available in the United States as of September, marking an increase of more than 200 in the last nine months, the Investment Company Institute says.

"You can get about anything you want now in the form of an exchange traded fund -- it's all out there," says Richard Ferri, founder and chief executive officer of Michigan-based investment management firm Portfolio Solutions and author of the recently published The ETF Book.

Here's a checklist from Mr. Ferri for investors trying to navigate the ever-expanding world of ETFS:

1. Understand the underlying index that makes up the ETF.
One of the biggest problems with ETFs over the last couple of years, says Mr. Ferri, is that the complexity of the indexes has increased.

"The indexes that a lot of the ETFs are following now are actual actively managed investment strategies that have been formed into an index," he says. As a result, investors buying ETFs don't always understand what is going on in the underlying index, but should at least know how the stocks are selected and weighted.

"The way that the underlying index is constructed is going to have a major impact on the performance of that fund - so know the index," says Mr. Ferri.

2. When comparing ETFs in like categories, look at the underlying fee.
There are many ETFs that are similar in what they're trying to do, says Mr. Ferri. "It really doesn't matter much whether you buy this one or you buy that one. Once you isolate the type of fund that you want to buy, then you need to look at the fee and you really should be buying the funds with the lowest fees."

3. The time of day you buy ETFs matters.
"You don't want to buy ETFs as soon as the market opens, and you don't want to buy them right before the market closes," he says.

The reason is that many of the stocks in the underlying index don't open up until at least 15 minutes after the market does, and the end of the day can bring a lot of volatility in the stocks as hedge funds and day traders "square up" their positions, he cautions.

"If you want to get a decent price for the ETF that is close to its underlying net asset value, then you probably want to buy 30 minutes after the market opens and 30 minutes before it closes - sometime during that period," he says, adding that will result in a narrower spread between the ETFs bid and ask price.

4. Understand the tax ramifications of the ETF that you're buying.
There are different types of exchange traded portfolios, says Mr. Ferri, and it is important to understand how the underlying taxes work if you're going to be putting the fund in a taxable portfolio. He also suggests investors who are doing their own ETF research should buy these vehicles through discount brokerage firms to keep their costs low.

5. Disclosure is important.
Mr. Ferri is working on a database that will include disclosure ratings for U.S. ETFs, that will likely be online in a few months at www.etfguide.com. The reason, he says, is that some ETF companies are providing investors with a lot of disclosure, while others are offering the bare minimum. ETFs should be disclosing information in detail, he says, so investors can understand its fees, how the index weights and selects securities and how it differs from the index, from the beginning.

Special to The Globe and Mail