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Written by Gary Gastineau
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Tuesday, 20 October 2009 00:00 |
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Page 1 of 10
 This is the first in a three-part series of articles that consider fund ratings and other methods used to select and evaluate funds, with emphasis on exchange-traded funds. I will examine the mutual fund and ETF economics that have a significant impact on fund performance and the nature of the guidance currently and prospectively available to investors and advisers as they make mutual fund and ETF purchase and sale decisions.
The Problem Of Fund Ratings
The reason for including mutual funds as well as ETFs in this discussion is that most widely cited analyses and ratings of ETFs are published by firms that also publish mutual fund information. It is not surprising that their ETF evaluations/ ratings are based on similar criteria to their mutual fund products, but there are at least five important—and sometimes strange—differences between typical ETF and mutual fund evaluations.
The Strange State Of ETF Evaluations And Ratings
First, anyone who reads very many articles about ETFs can’t miss the fact that ETF comparisons tend to focus much more heavily on fund expense ratios than most mutual fund evaluations do. This is puzzling because index ETF expense ratios vary less from fund to fund than mutual fund expense ratios. The emphasis on ETF expense ratios is partly the result of the ready availability of this measure. The expense ratio is one of the first things an investor sees when she examines the ETF’s “Fact Sheet.” Another reason for focusing on the ETF expense ratio is probably that, while mutual funds often have a number of share classes and fee structures, ETFs charge every investor the same fee. Finally, because ETF expense ratios tend to be lower than mutual fund expense ratios, expense ratios have been emphasized by ETF proponents in making the case for ETFs. This is far too much emphasis on a cost item that varies little among funds and is usually dwarfed by trading costs from index composition changes.
Second, as ETF trading volume has expanded, there has been increased emphasis on comparing the bid/ask spreads in the markets for various ETFs. The message investors receive from the focus on the bid/ask spread is the obvious one that a narrow spread is better than a wide spread when you are trading an ETF. This point is indisputable; but the numbers cited for an ETF’s average spread usually understate the spread an investor will encounter when she checks a live quote.1 Furthermore, for a long-term investor, the spread is paid only twice—once when she buys the shares and once when she sells them. The cost to trade ETF shares is important for a number of reasons, but trading cost will rarely be a make-or-break item for a long-term investor.
A third characteristic of ETF evaluation that differs strangely from mutual fund evaluation is that a great deal of attention is paid to ETF tracking error—a measure of the relative performance of the fund and its benchmark index. It gets a lot of attention because it is relatively easy to measure, but most fund raters are not sure what to do with it. I will discuss several definitions of tracking error and use one of them as a practical way to organize my fund performance analysis and evaluation.
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