Exchange-traded fund launches have continued to accelerate, but not every shiny new strategy is worth owning.
Why it matters: Good investment strategies can compensate investors with an appropriate return for the risks they take on. What kinds of ETFs are able to deliver over the long term, and which ones fall short? Dan Sotiroff is joining me today to explain the hidden risks in stock ETFs and what investors should look out for. Dan is a senior manager research analyst for Morningstar Research Services and the editor of Morningstar’s ETFInvestor newsletter.
11 Questions on Stock ETFs
- Can you talk about the idea that ETFs should be able to compensate investors for the risk they take on? What is an “appropriate level of return”?
- When looking at the risk and return profiles of ETFs, the term “active risk” often comes up. Can you give us a definition?
- What kinds of funds have the lowest active risk?
- Can you give an example of two ETFs that appear similar but take on different levels of risk?
- You’ve written that “any stock ETF with fewer than 100 holdings is a red flag.” Why is that?
- Does the management style of the fund make a difference for concentrated funds? Would a passive, index-tracking ETF run into the same issues as an actively managed ETF?
- Thematic ETFs are a popular example of concentrated portfolios with high active risk. How have they performed?
- Do investors tend to miss the timing on thematic funds? It seems like strong returns tend to be short-lived.
- At Morningstar, we often talk about fees as a predictor of performance. Do you see the same thing here?
- Should investors always choose a fund that takes on predictable risk? Or are there cases where higher active risk is worth it?
- What is one takeaway you have for investors that are trying to choose an ETF?
Key Quote on Stock ETFs
There’s a lot of evidence that a lot of the money tends to flow in at the top, right after they’ve had this huge runup in performance, and people are just, really, they’re kind of just chasing performance, for lack of a better term. The problem is they’ve seen all the upside.
Now the downside is going to come. So they experienced more downside than upside, and that’s where it gets really bad. And that’s not everyone. You certainly have those early adopters that really bought into the story, and they got in early on, and they saw some huge gains. But that isn’t really the common story that you hear. It’s more the latter where they tend to get in at the top.
Daniel Sotiroff, senior manager research analyst, Morningstar Research Services
The Takeaway: Sotiroff says there are different kinds of risk when it comes to ETF investing. The lowest active risk for investors is in broad market funds. The further investors stray away from a benchmark portfolio, the more individual company risk they take on, explains Sotiroff. Fees are still a predictor of performance, and Sotiroff says it’s better to stay away from expensive new investments and stick to investments with predictive power.
More From Morningstar on Investing in Stock ETFs
When it comes to ETFs, it’s about balancing risk and an appropriate level of return, says Sotiroff. Learn about the hidden risks in new ETFs and why it’s better to feel FOMO than sacrifice returns over the long term.
This year has provided an almost impossible hurdle for active managers to beat their passive peers. Bryan Armour explains how long-term trends can help investors find the right active investments amid volatility and uncertainty.
Looking for the best ETFs for your portfolio? Margaret Giles explains that the key is understanding the role of ETFs in your portfolio. Find out which ETFs Morningstar thinks are the best and why.
