This Day On The Street
Continue to site
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Judge an ETF by Its Fundamentals

When the world's first exchange-traded fund, the S&P 500 SPDR (SPY), was listed over a decade ago, things were simpler. People were broadly familiar with the underlying index, and, assuming an investor already wanted to track it, explaining the advantages and disadvantages of the ETF structure versus that of a comparable index mutual fund was the only analysis necessary.

Since then, however, the number of ETFs available to investors has exploded. The array of over 400 choices and the flexibility it brings is positive, but having so many choices also complicates the selection process. How do I know which ETFs make the most sense for my portfolio?

Perhaps because ETFs have always been compared with mutual funds, analysts have started to evaluate them as if they were mutual funds. Morningstar, for example, the large mutual fund rating outfit, says in materials on its Web site, "The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for mutual funds."

Therein lies the problem. Mutual funds are typically evaluated based on past performance and fees. That's appropriate for most of these products, which are actively managed, because what you are really doing is hiring a manager to invest on your behalf. But with ETFs, it's different. There is no active manager deciding when to buy or sell certain stocks -- no one, for example, deciding when to lighten up on a certain sector or when to increase exposure to a certain market cap segment.

There is nothing inherently good or bad about a particular index that an ETF tracks. Rather, the investment merit of an ETF is determined by two factors: market conditions and the fundamentals of the underlying stocks that comprise the fund. These, of course, change all the time.

This difference is like night and day: One is backward-looking, and one is forward-looking. Who is not aware that, over the past five years, technology stocks in general were a bad investment? What moderately informed investor doesn't already know that, over the same time period, small-cap stocks outpaced large-cap stocks?

If a mutual-fund manager failed to foresee changes in the economy and in the market and stayed overexposed to large-cap tech stocks, you'd have a valid complaint that he was probably not earning his keep. But the reason an ETF tracking an index of tech stocks, or an index of large-cap stocks, didn't change its portfolio is that it isn't supposed to -- it is just supposed to track the index.

1 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
SYM TRADE IT LAST %CHG
IJR $117.72 -0.13%
SDY $78.95 -0.11%
IWM $124.39 -0.29%
GE $27.50 -0.07%
AAPL $131.67 -0.28%

Markets

DOW 18,119.69 -43.30 -0.24%
S&P 500 2,119.06 -4.42 -0.21%
NASDAQ 5,094.12 -12.4730 -0.24%

Partners Compare Online Brokers

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs