In order to pick out a promising
exchange traded fund (ETF) in an orderly way, the first task of the investor is to compile a list of the top performers. For this purpose, the crucial factors include the pace of capital gains, the level of price volatility, and the burden of maintenance charges.
In certain cases, additional features may come to the fore. A case in point is the yield due to the dividends thrown off by the ETF.
For the most part, the traits noted above are interlinked rather than independent. As an example, an exchange traded fund on a growth streak is apt to be more volatile than a sluggish one which plods along at a modest pace. Another sample is the cost structure; whatever the performance in the past, an index fund with a heavy load is more likely than not in the future to lag behind its rivals with leaner structures.
In tackling these issues, a sensible step is to begin with a muster of the top 10 funds by way of growth. Then the other factors such as risk and cost can be brought to bear on the evaluation.
Top 10 ETF List by Growth
In preparing a roster of the top candidates, an obvious point of departure is the growth rate over the past several years. On a negative note, however, a lot of exchange traded funds are relative newcomers to the financial forum.
For this reason, the sources of information available to the investor might provide tallies of performance for only a few years into the past. A case in point is the section on ETF securities at the Web site maintained by Morningstar (morningstar.com).
The table below displays the exchange traded funds at the forefront of growth. As an example, the last row of the exhibit corresponds to an index fund called the SPDR S&P Pharmaceuticals. The purpose of this ETF is to replicate the total return – consisting of the capital gain plus the dividend yield – of the S&P Pharmaceuticals Select Industry Index.
The fund trades in the U.S. under the ticker symbol of XPH. According to the second entry in the same row, the vehicle deals with the health care segment of the stock market. Based on the last cell, the fund enjoyed an average annual gain of 14.41 percent over the course of 3 years ending in early 2011.
Clustering of Funds
The financial markets as well as the real economy have a way of advancing and retreating in an endless series of waves. The same is true of smaller tracts within the marketplace.
On the other hand, the undulation is far from uniform across the panoply of assets. Rather, certain segments of the market might swell while others shrink, and vice versa.
From the table above, we can see that four of the funds belong to the technology sector. Meanwhile, the health care segment boasts two pools.
A similar situation applies to the commodities sector as a whole, and the field of precious metals in particular. To be precise, the latter category contains a couple of contenders.
In addition, the market segment dealing with Latin America fields a single entrant. Finally, the category of Mid-Cap Growth rounds up the roster with one candidate.
Quick Scan of the Top ETF List
In reviewing an asset, it’s always helpful to get some idea of the performance under stormy as well as balmy conditions. A case in point is the behavior of a fund in the midst of a crisis, including its turnout during the most recent crackup of the stock market.
The chart below, courtesy of Yahoo Finance (finance.yahoo.com), presents the relative movements of all 10 stocks from the preceding table. The diagram covers a period of 5 years ending in early 2011.
In the midst of this stretch, a watershed lay in the financial crisis that erupted in the autumn of 2008. The impact of the fiasco is apparent in the middle portion of the chart.
One of the stocks can be seen clearly as an abnormal case. The outlier lay in BHH, a fund focused on Internet commerce. The pool suffered a big meltdown at the end of 2007, even before the financial flap erupted the following year.
After the wipeout, BHH began to recover starting in early 2009. Following the severe breakdown more than a year earlier, the fund was getting back on its feet from a low base. Due to the paltry price of the stock, even a modest increase of a few cents could result in a hefty rise on a relative basis.
Given this backdrop, it’s not surprising that BHH should clamber upward at a decent pace in the subsequent years. The fund was merely recovering some of the whopping losses it had suffered before and during 2008.
On the other hand, BHH still has a long way to go on the road to recovery. At this juncture, the price of the stock hovers around a single dollar.
As a rule of thumb, any equity priced under $5 per share is considered to be a
penny stock. Moreover, a lot of stocks with such lowish prices tend to be highly volatile. For this reason, myriads of investors refuse to consider penny stocks as serious candidates for long-term investment.
Worse yet, there is an even bigger problem with BHH. Although the fund encompassed a larger batch of stocks in the past, all but two have fallen by the wayside over time. In other words, the pool has come to comprise only a couple of equities at this juncture.
In general, a basic appeal of an ETF is the coverage of numerous equities as a way to spread out the risk of a big smackdown resulting from the wipeout of a single security. If a fund contains only a couple of stocks, however, the level of diversification is hardly worth talking about.
Given this backdrop, BHH suffers from the stigma of being a penny stock as well as the risk entailed by a dearth of diversification. Due to these flaws, we will forgo any further consideration of the vehicle here. In other words, we reject BHH at this stage as a suitable candidate for investment.
Matchup of Risk and Return
We have already eliminated one of the funds from the original lineup of high flyers. From this point onward, we will take a closer look at the remaining 9 entries in the foregoing table.
PowerShares Dynamic Networking
The second security in the previous table is PXQ. The aim of this fund is to track the Dynamic Networking Intellidex Index, a benchmark that covers several dozen firms ranging from Qualcomm and Cisco to Symantec and Netgear.
For the sake of consistency in comparing the funds, we will rely for the most part on the data provided by Yahoo Finance.
Toward the end of 2010, PXQ issued a small dividend of 10.733 cents per share. Meanwhile, the current price floats in the vicinity of $26.16. The ratio of the latter two figures is about 0.41%.
Suppose that this payout turns out be representative of the annual dividend in future years. Moreover, we will assume that the average gain in price of 18.64% per year seen over the past 3 years will continue to prevail going forward. Based on the last two rates, the total return for the investor would come out to 19.05% per annum.
The net expense for the pool happens to be 0.63% a year based on the current value of the portfolio. In one sense, this figure is only of secondary import to the investor. The reason is that the burden of maintenance fees would be baked into the price of the fund on the open market.
On the other hand, the level of expenses is a measure of the efficiency of the custodians. Other things being equal, a lean pool is likely to perform better over time than a bloated one.
We turn now to the flightiness of the asset. A standard yardstick of volatility is found in a factor called beta, which measures the average jitter of a security compared to the market at large.
Based on the behavior of PXQ over the past 3 years, the value of beta was 1.22. From this figure, we can infer that the stock tends to swell by 1.22% whenever the market at large rises by a single percent. In other words, the security is somewhat more volatile than the market as a whole.
Another way to measure the flightiness of an asset is to determine how much the return on investment varies over time. As an example, suppose that a stock named Al enjoyed an average gain of 9 percent a year over the past decade, with scant variation in performance from one period to the next.
By contrast, consider an equity named Bo which also managed to rise by 9 percent a year on average over the same time frame. On the other hand, the returns for this asset varied widely from one year to the next.
In general, investors have a penchant for high growth just as they have a distaste for high risk. In comparing Al and Bo, the duo turned in the same performance in terms of the average rate of growth. Yet the risk for Al was lower. As a result, Al would be chosen over Bo on the basis on
risk-adjusted returns.
In gauging the dispersion of returns, the usual figure of merit is a yardstick known to statistical wonks as the
standard deviation. The latter feature is usually denoted by the Greek letter
sigma.
For this reason, we could refer to the standard deviation as the sigma factor. The higher the value of sigma, the greater is the scatter of payoffs. In other words, the risk due to turbulence turns out to be higher.
The standard deviation could be computed from the raw price of the stock in terms of absolute dollars. Another way to approach the subject is to calculate the return on investment from one period to the next, then figure out the standard deviation of the sequence of relative payoffs.
The latter scheme is the usual procedure adopted by the financial community. Its advantage lies in the ease of comparing the flightiness amongst diverse assets.
As noted earlier, investors are fond of high returns at low risk. One way to combine both these factors into a single yardstick is to divide the average gain by the sigma factor. The latter quotient is known as the
Sharpe ratio.
The Sharpe value is the usual measure used by financial jocks in gauging the risk-adjusted return. As an example, suppose that the average return on a stock called Cy happened to be 10% per year, while the sigma factor was 20%. In that case, the Sharpe ratio would be to 10/20; or 0.5 in decimal form.
At this stage, we should note that the average dispersion can exceed the average return since a stock can experience large drops into negative territory. For instance, consider a stock named Di which rose by 50% during the first year, then fell by 40% in the second year. Over the 2-year span, the security had an average return of 10%; but the divergence of the payoffs was enormous.
Clearly, a high value for the Sharpe ratio is better for the investor than a lower one. As a baseline for comparison, we invoke the corresponding figure for the most common benchmark of the stock market used by professionals; namely, the S&P 500 index. A fact sheet at Standard & Poor’s (standardandpoors.com) indicates that the Sharpe ratio for the benchmark over the course of 3 years ending in early 2011 was a mite under 0.33.
We turn now to the risk and return for the PXQ fund. For this pool, the Sharpe ratio over the past 3 years was 0.46. The performance appears to be significantly better than the turnout for the S&P 500 index.
Rating the Rest of the ETF List
The remaining stocks from the table above can be scrutinized in a similar fashion. For the sake of brevity, though, we will refrain here from going into every little detail.
Rather, this portion of the article will present an overview of the feasible candidates. In particular, the survey focuses on the range of values for the key properties displayed by the ensemble.
For the muster of 9 funds, the annual charge for maintenance fees varied from 0.35 to 0.63 percent. At the low end of the range were the RFG and XSD pools. The high end of the scale was anchored by PXQ.
The yield due to dividends varied from 0 to 0.91 percent. The funds offering no payout at all were PXQ, FBT, SLV, DBS, and FDN. The most generous yield, such as it was, came from ECH.
Meanwhile, the value of beta varied from 0.66 to 1.31. The low end of the span was taken up by ECH and the high spot by XSD.
Finally, the risk-adjusted gain according to the Shape ratio ranged from 0.27 to 0.75. The laggard was XSD while the leader was DBS. Moreover, SLV deserved an honorable mention with a rating of 0.74.
Index Funds and Raw Commodities
As we saw earlier, an ETF which covers only a couple of stocks is much too narrow to be considered by the majority of investors. Stocks can and do break down for any number of reasons whether or not the firms standing behind the securities happen to operate in thriving markets.
As an example, a fusty business might be trounced by an upstart rival armed with a newfangled product. Meanwhile another hapless firm could succumb to an accounting scandal, a class-action lawsuit, or some other type of mishap.
For these reasons, an index fund ought to cover a sizable selection of firms in order to withstand the meltdown of any single stock without causing the pool as a whole to collapse. In this context, a roster of perhaps 10 members might be viewed as the minimal number needed for adequate protection against the occasional crackup of the elemental securities.
By contrast, the commodity market is more resistant to a total wipeout. A case in point is silver, whose price is determined by the matchup of supply and demand in a global forum. In particular, the demand for silver stems from its use in a host of products ranging from jewelry and ornamentation to utensils and microelectronics.
Granted, the commodity market is subject to a raft of threats as well. An exemplar is a global recession that craters the demand for silver.
On the other hand, the price of the white metal is unlikely to break down completely and flop to zero anytime soon. And even if it did, the market is bound to recover sooner or later.
Thanks to the hardy streak, a commodity can be far more robust than a security issued by a lonesome company. For this reason, an index fund that tracks a natural resource should not be rejected outright for the mere reason that it happens to cover only a single commodity.
There may be a slew of reasons why a particular fund in the commodity market could be problematic. But the lack of diversification is not necessarily one of them.
For some types of investors, a focused pool in the market for raw materials might be a perfectly fitting choice. The decision could be especially apt if the security were to complement the other holdings within a larger portfolio.
With that matter out of the way, we can get down to the business of comparing a couple of similar funds in the foregoing table. As it happens, two of the pools focus on the market for silver bullion.
Index Funds based on the Commodities and Futures Markets
In the case of the SLV fund, the pool holds a stockpile of silver bullion. By contrast, the DBS vehicle tracks the same market by buying and selling contracts for the white metal on the futures market.
For SLV, the net cost of maintenance came out to 0.50% on an annual basis. The corresponding figure for DBS was 0.54%.
Neither fund gave off any dividends. Moreover, the value of beta for SLV was 0.89 while that for DBS was 0.92.
The foregoing statistics from Yahoo came from a database spanning a period of 3 years ending in late 2010. Judging from the results, DBS was slightly more turbulent than SLV over this period.
From a different angle, the Sharpe ratio for SLV turned out to be 0.74 while that for DBS was 0.75. Apparently, the latter pool enjoyed a slim advantage in terms of risk-adjusted gains.
Another slant on the subject is provided by a research outfit named the RiskMetrics Group (riskmetrics.com). The market watcher gives more weight to newer observations over older ones.
In other words, the behavior of an asset in the recent past counts more than the action that went before. The resulting statistics are published at a site called RiskGrades (riskgrades.com).
The basic trait tracked by the agency is the return on investment from one day to the next. In the next step, the average value of the payoff is calculated while giving a bit more weight to the observation for a particular day compared to the average level obtained from the previous day of trading.
At the next stage, the value of sigma for the target asset is divided by the corresponding figure for a basket of equities traded on a number of stock markets round the world. Finally, the resulting quotient is multiplied by 100 in order to express the outcome as a percentage rather than a fraction.
Put another way, the RiskGrade for a basket of global equities is defined to be 100 units. Moreover, the level of risk for a given asset is presented as a percentage of the reference value.
For a simple example, consider a fund named Fay whose RiskGrade happens to be 150. The latter figure indicates that the pool is 50 percent more flighty than a representative basket of global equities.
Over the course of 3 years ending in early 2011, the average level of risk for SLV was 191. At the end of the stretch, the value of the yardstick came out to 162.
By contrast, the mean level for DBS over the 3-year stretch was 197. Meanwhile, the latest figure stood at 163.
From the foregoing batch of statistics, SLV appears to be a wee bit less volatile than DBS. Moreover, the performance figures in the previous table show that SLV grew a tad more quickly as well.
In view of these results, we can conclude that SLV enjoyed a slight edge over DBS based on the RiskGrade yardstick. One reason for the small gap in performance for the two funds doubtless lay in the distinction between the commodity market and the futures market. According to the statistics, the latter market appeared to be slightly more volatile.
To be precise, the price of each fund was of course determined by the behavior of the investors in the
stock market. For this reason, we could be a bit more accurate and say that the difference in performance for SLV and DBS stemmed from the mindset of the participants in the
equity market regarding the prospects for the
raw commodity versus the outlook for the
futures market.
Whatever the cause of the discrepancy, the differences between the two funds were paltry. And that was just as well.
In fact, a sizable gap would have been a cause for concern. After all, from the standpoint of the investor, the ultimate function of both vehicles is to keep up with the market for silver bullion.
Winning Traits
The top 10 funds based on growth featured a medley of traits in terms of risk and cost. Based on the data over a 3-year stretch, the best candidate in each category was as follows.
- Top Growth: 18.64% a year on average for PXQ
- Least Risk (Beta): 0.66 for ECH
- Least Cost: 0.35% a year for XSD and RFG
- Best Risk-Adjusted Returns (Sharpe): 0.74 or better for SLV and DBS
To sum up, the best performers on a risk-adjusted basis were SLV and DBS. Or we could just say that the winner of the beauty pageant was silver bullion.
Tailored Choice
The procedure presented above can serve as the groundwork for selecting the best fund for a personal portfolio. One important issue that lies beyond the purview of this article is the need for each investor to assess every candidate in light of personal circumstances.
A prime example lies in the tolerance for risk. Another factor is the way in which a pool complements the other assets within a larger portfolio.
Given this backdrop, the best choice of ETF for one person could well be a lousy pick for someone else. For instance, a particular investor might decide that a high rate of growth is not worth the big headache caused by the violent thrashing of prices.
Moreover, the serious investor consults several sources of information in order to obtain a sound and rounded view of the choices under consideration. A case in point is a confirmation of the past statistics as well as the current status of an ETF. Another sample is the long-range outlook for the target market tracked by an index fund.
Whatever the final decision, though, a list of the top 10 performers is a good place to begin the quest for a winning ETF.
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