The Best ETF Investing Guide You’ll Ever Watch!
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ETFs are a newbie investor’s best friend. They are a great way to own a diversified portfolio while only actually buying a couple of tickers. An ETF is a diversified basket of stocks that trades as a single fund under one ticker on a stock exchange. These funds can be passive or active. Passive funds track an index, such as the S&P 500. Active funds look to outperform an index. (Spoiler alert: most don’t succeed.)
There are over 10,000 ETFs out there all trying to take your hard-earned money. If you find that overwhelming, you’re not alone. I spent over a decade supporting some of the largest ETF managers in the world. What I learned is that ETFs are far more complex than you can imagine. But they’re also very easy to navigate with the right guidance.
may be one of the most valuable investing videos you’re going to come across whether you’re a newbie or an expert investor. And I’m also going to tell you which ETFs are best for beginner investors. Yes, actual names to invest in. So let’s start at the top.
What is an ETF?
An ETF is an Exchange Traded Fund. It’s what it says on the tin. It’s a fund or a basket of assets that trades on an exchange like a stock. Now the most popular ETFs usually just contain stocks but they can also contain bonds or even Commodities. So a gold ETF might just be a basket of physical gold or it might be a collection of gold mining stocks. But today, we’re going to focus on stock ETFs because these are what you’re going to come across most commonly in the wild.
Passive vs Active ETFs
There’s two types of ETFs you need to know about. There’s passive ETFs and active ETFs.
So very simply put, a passive ETF manager simply tries to return the performance of a benchmark or an index. An index is a collection of stocks. An active manager tries to beat that index instead of matching the performance. They say, we can outperform the index. Now in the case of passive ETFs, these are highly preferable because they’re transparent. You can simply look at the index to understand how the ETF works. In the case of an active ETF, these are often black boxes. They’re very opaque. So a good example would be ARK’s ETFs.
Probably the biggest reason to avoid active ETFs would be the fact that they charge a lot higher fees.
So passive ETFs now have very, very low fees. So Morning Star did multiple studies and what they found was quite remarkable. So what they found is that if enough people make comments on social media using nothing but emojis for their favorite stock, the price goes up. No, actually, I’m joking, that’s not the case.
What they found was that low fees are the biggest predictor of a fund’s performance and, intuitively, that makes sense. Now it seems like common sense but you’d be surprised at how many investors don’t pay close enough attention to fees.
Here’s the biggest problem. Active ETF managers charge more fees but, yet, only 5% of them can beat the Benchmark. In other words, investing with an active manager, 95% of the time you’re not going to outperform the Benchmark. You might say, why would I ever pay extra money to an active manager so they can’t beat a benchmark? That’s a really good question.
That’s why you should only focus on passive ETFs. As I said, when you look at the constituents or the members of an ETF, the stocks that it contains within, so for a passive ETF, you simply look at the index. And if you want to understand any given ETF, you’re going to need to understand the index.
So all passive ETFs are going to track an index. It could be created by the ETF provider. But it’s typically created by a third party. Now MSCI, the firm that I worked for for over a decade, we created over 280,000 indices for our clients.
That’s about 10 times as many US stocks that have ever existed. And they’re just one index provider. Every one of those industrial strength indices can have a financial product attached to it.
And the other thing, I think, that a lot of investors don’t understand is that when BlackRock and Vanguard hold shares of a particular company, like let’s say IonQ, it’s not because they believe in the future of Quantum Computing.
It’s because the size of the company dictates that it ought to belong to a particular index. And when it gets added to a particular index, then shares need to be bought and that, because there’s a lot of financial products tied to that index and that creates price action, which affects a particular company. So always distinguish between passive and active bets when you’re looking at firms that hold a particular stock.
ETFs and Indices
So if you want to understand how indices work. When someone started on our desk, this is one of the documents that we gave them to sit down and read. And it’s the MSCI Global Investable Market Indices Methodology and this will, I think, give you an idea of just how complicated this domain is.
This is a 207-page introduction to the world of indices. Now you don’t care about that stuff, you care about ETFs. And what happens with an ETF, and we continue using MSCI as an example, is that they’ll license an index from MSCI.
So maybe they’ll pay 10 basis points, five basis points, half a basis point, I don’t know. MSCI is actually quite expensive. They have the best research team in the industry. But that ETF provider pays a licensing fee to MSCI and then what they plan to do is offer the performance of that MSCI index to investors. Plain and simple, right?
A passive ETF manager who outperforms the index didn’t do their job. Their job is to offer the performance of that index as close as possible minus the fees they’re charging, okay? So this term’s important to understand. It’s called tracking error. That’s simply the difference between the index performance and the ETF’s performance, all right? So that should actually simply be, ideally, it’s zero but it’s going to be the index performance minus fees, right? And we’re going to look at that.
Now the mechanics of an ETF always reflect the underlying index methodology. You want to understand how an ETF works? We do this all the time on this channel. We go and take a look at the index and dig into how that works and we do that by reading through methodology documents like the one I showed you from MSCI.
If we think about stock indices and all stocks in the world, that’s a great place to start. That would be an interesting universe to invest in, right? Well, that’s called the MSCI ACWI and it represents 99% of the investable stocks in the world.
And here you can see where it’s further broken down into MSCI World, that’s developed markets; MSCI Emerging Markets, then we have all the countries, right? What they do is they start slicing and dicing. You can see where they’re slicing and dicing by size.
So large and mid, what we used to call Standard, I think, they call it Core now, represents 85% of all stocks, right? They’re looking at that by market cap, then small is 14%. So you can start to carve out, for example, MSCI Emerging Markets small cap. Then what you can do is you can carve that down even further. You could say, I want MSCI Emerging Market small-cap growth, right? So you can start slicing and dicing this universe even further by value versus growth or momentum or yield.
And what you end up with, based on all the indices out there, is then a list of ETFs. And I’ve put here the largest ETFs out there, the top 100 ETFs by assets. This is taken, I think, from VettaFi, you see the top 10 here.
We read through, you know, going down the list S&P 500, the 500 largest companies in the United States. Very popular Benchmark, right? Vanguard Total stock market. That’s not just the 500 largest, that’s all the stocks in the United States. Then you have QQQ, that’s NASDAQ. Then look, Vanguard Growth. Well, what is that Vanguard Growth all cap? I don’t know. We’d have to go and start looking at the index, right? So you see how this stuff works.
Now people say, well, which ETFs should I buy? Well, first of all, investing isn’t just about stocks. You can also have other asset classes, as I mentioned earlier, such as bonds or real estate or alternative assets. Gold would be an alternative asset. So venture capital or Commodities.
The Three-Fund Portfolio
But one simple effective strategy that we talk about quite a bit is a three-fund portfolio. This is from Bogle. He’s the Vanguard guy who brought us low-fee investing, thank the Lord, right? So keeping it in the family, here we’re we’ve given you examples from four large ETF providers of what a three-fund portfolio might look like.
And if we take BlackRock there at the top, so you have iShares Core S&P Total Market ETF that would represent the United States. Then you have a- look, there’s MSCI. MSCI Total International Stock ETF. And the ticker tells you something. IXUS. So it’s XUS. Make sure that you’re International.
Doesn’t include the US, otherwise you’re double counting there. You have overlapping exposure. Then you have bonds. So US Stocks International stocks and bonds. Some will say, well, you ought to have international bonds. Well, fine. All right, so you can make it a four-fund, if you want. There are also ETFs that claim to offer this sort of exposure such as the iShares, the multi-asset income ETF. But always, pay attention to fees. Look at they’re charging here, 49 basis points.
The privilege of these fund of funds, man. You got to be careful. You’ll get double charged. So you’ll have an ETF that holds other ETFs and that their charging fees. Now you got to be really careful about this stuff.
All About ETF Fees
And this brings us to the most important part of this presentation which is going to be around fees, okay? I love this chart here from justETF Research. It’s the total cost of ownership for an ETF investment.
So we’re going to focus on internal costs, Total Expense Ratio. That’s what you want to pay attention to. And as I said earlier, remember, it’s going to be the performance of the index minus the expense ratio is going to give you your tracking error. What they call here tracking difference.
Now I don’t think most ETF providers actually refer to this as tracking error or tracking difference in their investment collateral. Simply look, and they all have this, for the performance of the ETF against its Benchmark. And look at the difference over time. That’s what you’re paying attention to.
It should be the expense ratio. Now if it isn’t, there’s various reasons for that. And three major reasons are here and we’re going to talk about these because they’re important. Well, they’re relevant and you ought to know them, right, because if you’re going to have more than a basic understanding, I think that’s useful. Rebalancing costs. Swap Spread and Securities Lending. Let’s start with Rebalancing Costs. So physical replication.
How does that ETF provider match the index performance? Well, the intuitive way they might do that is simply to go out and buy every single stock in the index and then adjust that waiting accordingly. And that’s what they do. It’s called Full Replication.
Vanguard says, in as many cases as possible, we try to use full replication, all right? Fair enough. Well, there’s other methods too. Also, what’s called Sampling. That’s where you don’t buy all the stocks, you just buy some or optimization, where you do the same but then you configure it over time. And there’s various reasons why firms do this. A lot of it has to do with illiquid stocks and such.
So when you move away from Full Replication, tracking error increases. It becomes more difficult to manage and it becomes more expensive to manage. So suddenly your transaction costs start to go up. So if you want to know what sort of replication method an ETF is using, again, if we just check tracking error, it covers all this, right?
But if you wanted to understand that better, go look at the the number of stocks being held in the ETF and the number held in the index. So this is typical information provided in a fact sheet or on a ETF website, right? And that will tell you very quickly if the numbers are nearly identical, you know they’re using full replication.
Another method of replication that I think is very suspect would be what they call synthetic replication.
So this is where the idea of a swap spread starts to come into play if an ETF isn’t holding the assets of the underlying index and they’re using swaps. You might might want to avoid it. I think an example that would be Cannabis ETFs in the United States where they’re not legally allowed to hold cannabis stocks. So they use swaps instead and you start to have counterparty risk. It gets more expensive. So be very wary of synthetic replication or leveraged ETFs or anything where they start to get too fancy. That’s never, in the history of the financial world, benefited the end investor.
Security Lending in ETFs
And then that brings us to Securities Lending. This was brought up in our Discord server. We had some good conversations around this. It’s a complicated topic. And Vanguard here, they pose key questions for Securities lending.
So the idea being that if you wanted to start grilling your ETF provider about their Securities lending activity, that’s where they lend out Securities that they’re holding within their ETF to people that want to short particular stocks. These are questions that you might ask.
I like this first question, how much of the gross revenues from security lending are allocated to the ETF and how much is passed on to the funds manager? Oh boy. They talk about borrower default indemnification. So what happens if there’s a default? This is counterparty risk.
Key Takeaways
And this brings us to, perhaps, one of the most important takeaways from this presentation, honestly.
Reduce your risk and lower your fees. Stick with the most reputable ETF providers out there. Competent firms like BlackRock, like Vanguard. They police manager performance and manage their risks, okay. And if something goes south, they’re going to make their customers whole because their reputation is extremely important within the industry.
Invest in heavy AUM products. What that will make sure of is that you’re investing alongside institutions who will understand the game, all right, better than you will. And you can see this is an interesting graph showing individual investors and how much of the total US-listed ETFs out there they’re holding.
It’s around 20%. That’s actually higher than I thought. So that means 80% of all ETF activity or ETF investing is done by institutions. So if you’re investing alongside institutions, you’re not going to run into any problems. Stay away from small ETFs. Small ETFs are typically active managers. Again, we covered that. You don’t mess around with active management. Always use fees as a determining factor when you’re comparing ETFs.
Now low-cost providers like Vanguard, we would tend to lean towards because they’re going to lead the charge when it comes to low fees. So maybe temporarily one of their competitors is offering better fees, well, they’re probably going to play catchup real quick because that’s what their reputation is. Remember that lesson, right? Tracking error should always be index return minus the expense ratio.
So going back to this great chart here. So when you’re looking at that ETF and you want to see how well it’s performed, you simply see how close it came to offering you the performance of the underlying index.
So some other questions investors would ask:
Can I lose all my money investing in an ETF? As we said, well, this question refers to systemic risk. If you stick with major providers and high-AUM products, you’re going to be just fine. If everyone gets burned, I think we have bigger problems. Are there ETFs you should avoid? Well, yeah, stay away from anything synthetic, anything exotic, leveraged stuff like that. JEPI is quite suspect from where we’re sitting. We’ve covered that in a previous video.
What about zero-cost funds? Sure, these are usually loss leaders. They’re lending Securities to help pay for costs. There’s no portability. So if you leave that firm, you can’t take that product with you. I would stick with Fidelity or Vanguard when you’re looking at those types of products. For reasons that we’ve talked about. Now people might want to know more about that three-fund approach. Well, fine. Let it be so.
Here’s a piece we did on three-fund portfolios. It’s very edifying. thank you so much for taking the time to watch this today.
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