Exchange-traded funds (ETFs) have become a lot more popular over the last 25 years. They are considered to be more cost-effective than mutual funds with lower costs of diversification and a wider variety of options for trading and arbitrage. Despite being the subject of criticism for volatility in markets, few can doubt the utility of ETFs in providing investors with greater exposure to a wider range of markets and classes of investments.
Investing in ETFs
The market for ETFs is more competitive than ever, with wider varieties of products made to attract investors. This makes it a lot more difficult for investors to determine which ETF investments present the best prospects for profit gains.
Several considerations need to be made when deciding on the best ETFs to invest in. Such considerations include leverage, lending policies, expense ratios, level of assets, trading activity, underlying assets, tracking error, and market position.
Lending Policies and Trading Volumes
Securities lending involves investors paying money to borrow shares. ETFs have different securities lending policies. ETFs may have a revenue-sharing policy for investors whereby they gain from securities lending revenue. For some investors, ETFs that engage in such activities may be considered as too risky.
ETFs with leverage also carry significant risks. Such ETFs can provide significant returns in favorable markets but present very high risks when market activity is negative. Also, in the long-term, high fees of leveraged ETFs may eat into profits made.
The assets of an ETF may be indicative of the amount of interests which investors have in it. With greater interest from investors, liquidity may increase. Many view $10 million in assets as the minimum amount which ETFs with good prospects for profitability should have.
Trading carried out by an ETF can also serve as an indicator of investor interest and liquidity. Higher trading volumes increase the likelihood of the ETF improving its liquidity. This makes it easier to make entries and exits from the ETF. Investors may also benefit from wider spreads with ETFs that have higher liquidity.
Diversity, Tracking Error, and First Movers
The diversity of the asset class which an ETF is based on can be a reflection of the risk management practices of the firm. ETFs focusing solely on specific industries or locations may be considered by some investors as too risky on account of the ratio of exposure to specific industries or geographic regions.
If possible, investors should pay close attention to tracking error by ETFs. Tracking error is typically used to measure the performance of investments, revealing the difference between the consistency of investments and a benchmark.
With ETFs, time is of the essence. ETFs with first-mover advantage have a greater chance of acquiring more shares. ETFs that do not have first-mover advantage may fail to may be less competitive with less investors. As a result, they may have less liquidity.
Expense ratios tell a fascinating story about the prospects of ETFs. Expense ratios reflect the price-competitiveness of ETFs. Funds with lower expense ratios allow for lower fees for investors.
Calvin Ebun-Amu is passionate about finance and technology. While studying his bachelor’s degree, he found himself using his spare time to research and write about finance. Calvin is particularly fascinated by economics and risk management. When he’s not writing, he’s reading a book or article on risk and uncertainty by his favourite non-fiction author, Nassim Nicholas Taleb. Calvin has a bachelors degree in law and a post-graduate diploma in business.