An Exchange Traded Fund (ETF) is a security that tracks an index, a commodity or a set of assets — just like an index fund — but trades each day like a stock on a given exchange. Also like a stock, the price of an ETF changes throughout the day as it is bought and sold by investors.
ETFs are a relatively new investment, but since their initial launch in 1993, they have rapidly multiplied not only in number, but also in size. There are over 1,500 ETFs available today, with 40 of the largest each holding over $10 billion in AUM (assets under management) according to ETF Database – led by the behemoth SPDR S&P 500 ETF (NYSEARCA: SPY) with $170.8 billion in assets.
What are the benefits of investing in ETFs? Mainly, they are diversification, flexibility and fee savings. When you purchase shares in an ETF, you gain the diversification of a mutual fund, with the added flexibility to buy on margin and sell short. You can also purchase as little as one share, and the fees are typically lower than those charged by mutual funds.
What about ETF size — does it really matter? It can, but only up to a certain point. A small ETF that has failed to gather enough investor interest to have sufficient funds can have difficulty operating through poor liquidity. Thus, a relatively new ETF should gather enough initial interest to meet this informal threshold in a relatively short time – a rough guideline is around $25 million in AUM and a daily trading volume of at least 25,000 shares.
An informal study on the ETF Database website attempted to address this issue by dividing ETFs into blocks of daily trading volume and comparing their price to the NAV (Net Asset Value) of the ETF. Above the 25,000-trading threshold, ETFs were within 0.5% of their NAV in either direction 98-100% of the time; from 10,000-25,000 daily shares, the value was 80%; and less than 10,000, only 40% of the time.
The study suggests that below that trading threshold, funds have liquidity issues, and risk premiums may be built into the price. They may still have a place in your portfolio; they just represent different levels of risk. In fact, four of the top ten YTD returns in Morningstar as of this writing are below the $25,000,000/25,000 daily volume threshold, with all four in riskier commodities and all with returns above 50%.
That is also why size does not necessarily matter for the largest funds – they have sufficient liquidity. What matters to you as an investor is the risk involved with the ETF and whether the return is proportionate to that risk. That in turn depends on the holdings of the fund and the index or target that it is following.
Let’s look at some of the largest ETFs in more detail.
- SPDR S&P 500 ETF (NYSEARCA: SPY) – Tracks the S&P 500 with large cap equities. Top holdings include Apple, Exxon Mobil, Microsoft, Johnson & Johnson, and General Electric. Returns: 9.01% YTD and 118.63% return over 5 years. (The second largest ETF, iShares Core S&P 500 ETF (NYSEARCA: IVV) is extremely similar in holdings and returns.)
- iShares MSCI EAFE ETF (NYSEARCA: EFA) – The third largest ETF invests in foreign large cap equities – EAFE stands for European, Australasian, and Far Eastern. Top holdings include Nestle, Roche, HSBC, Novartis and Toyota. It also contains significant energy stocks – the next three on the list are Royal Dutch Shell, BP, and Total SA. Returns: 1.998% YTD and 52.34% over 5 years.
- Emerging Markets ETF (NYSEARCA: VWO) – The fourth largest ETF invests in large and mid-cap equities in emerging markets. Top holdings include Tencent holdings, TSMC (Taiwan Semiconductor Manufacturing Corporation), China Construction Bank Corp, China Mobile, and Naspers. Over 40% of the holdings are in emerging Asian investments. Returns: 11.21% YTD with 44.14% over 5 years.
Other contrasting large ETFs include the SPDR Gold Trust ETF (NYSEARCA: GLD) the 8th largest ETF which tracks the spot prices in gold bullion; REIT ETF (NYSEARCA: VNQ), the 9th largest ETF with holdings in Real Estate Investment Trusts; and the iShares Russell 2000 ETF (NYSEARCA: IWM), the 13th largest ETF which deals in small cap stocks on the Russell 2000 Small Cap Index.
In one important way, ETFs are like any other investment – they represent a range of risks and market sectors, even with the largest ones. As a result, they are going to fit into your portfolio in different ways.
For all but the smallest ETF’s, you can ignore the size, and assess the historical risk/reward, along with the forecasts for the underlying holdings – because in the end, size really doesn’t matter all that much.