What ETFs to Invest In
A 5-Step Guide to Selecting Winning ETFs in a Crowded Market
When considering what ETFs to invest in, it’s hard to imagine a time when there were none. ETFs offer appealing opportunities, with the first one, SPY, appearing in 1993. It didn’t skyrocket to success right away, though.
It took five more years for DIA, the Dow Jones Industrial Average ETF, to come along. Even though the beginnings of the ETF industry were a bit humble, that all changed in the early 2000s when the industry started to increase.
Nowadays, 30 years later, the world has over 5,000 different ETFs.
This causes a bit of overload, especially for new investors. Here is a five-step guide on how to select the winning ETFs in such a crowded market.
1) Assets Under Management for the Strategy
Popular ETFs that follow the S&P500, like SPY and VOO, have both 500 billion USD under management. Multiple other, smaller ETFs follow the same strategy. We estimate that there are probably close to 2 trillion. USD in ETF assets following S&P500.
Many investors believe in the strategy. That makes it a bit like TOYOTA RAV4 of the ETF industry – probably not the best in any category, but entirely satisfactory in the long run.
We can say similar things about NASDAQ-100 ETFs – QQQ ETF alone has nearly 250 billion USD in assets, with almost 300 billion USD in assets following NASDAQ-100, so investors should feel reassured that the ETF following the strategy has investment merits.
So, where is the cut-off, if there is any? It is not so easy to say, but in our opinion, if an ETF strategy has more than 40 billion USD in assets, that strategy is proven or, at the very least, widely accepted.
It does not mean that if an ETF has only 10 billion USD in assets, we would not invest; it is only that we would be very cautious about investing in it.
2) 10-Year Historical Returns
Investors often fall prey to “low PE ratio” portfolios or ETFs. Low PE is a good attribute, but if the ETF has returned 5% annually for the last 10 years, while QQQ has returned 20% annually while being perennially “overpriced” how good is that ETF?
Again, there are no easy shortcuts or explicit formulas here. We prefer low PE ETFs, but if their 10-year historical return is significantly underperforming S&P500, we would avoid them.
Investors perceive ETFs that follow value, dividend, and low-volatility strategies
3) PEG Ratio Comparison (3-5 Year Expected Earnings Growth)
This information is only readily available for State Street Global Advisor-sponsored ETFs. However, if seriously interested in an ETF, we would construct an excel spreadsheet with the weights of each stock and the analyst’s expected earnings for the next 2-3 years. Those analyst’s projections can be found on Bloomberg terminals or the Nasdaq website. We would compare the resulting growth rate with the forward PE ratio of the portfolio.
For example, SPY has a forward PE ratio of about 21 while the expected 3-5 year earnings growth is around 14%, according to State Street Global Advisors. That makes the PEG ratio of 1.5 (21/14).
Ideally, we would invest only in ETFs close to that 1.5 Ratio.
Again, this is not as clear cut as it sounds, but it is a perfect point to consider
4) Avoid Value, Dividend and Low-Volatility ETFs
ETFs that follow value, dividend, and low-volatility strategies are perceived by investors to be safer. In reality, during bad times like COVID-19 in March 2020, they lost nearly as much as the market.
However, in good times, they tend to lag quite a bit. We see statistical evidence of why one should invest in growth ETFs but not in any other strategy.
5) Fees and Portfolio Annual Turnover
While most investors are mindful of ETF fees, some ETFs turn their portfolio so often that a substantial value is lost due to trading. Examples here are numerous – most commodity-based ETFs would be in that category, like VXX, USO, and UNG. The same can be said about leveraged ETFs, especially 300% ETFs.
Key Takeaway
In conclusion we are going to say that while at present there are over 5000 ETFs worldwide, in reality many of them are really too exotic, with inferior or relatively volatile track record and very often with little assets under management. If you apply the steps listed above correctly, you will find out that there are no more than 100 or so ETFs worldwide that pass our screening 5-step process.
To paraphrase Mr. Howard Marks, the founder of Oaktree Capital, “investing is like amateur tennis – all you need to do is return the ball”. Many investors, especially young investors, make the error to seek excessively high returns – invariably choosing a Lamborghini ETF rather than the RAV4 of ETFs (ETFs based on S&P500 or NASDAQ-100).
It takes quite a long time to ascertain that the “win big or go home” mentality of many investors usually ends up with going home. Choose and choose wisely. Choose hits over home runs.