ETF Center

Since their introduction, exchange-traded funds (ETFs) have become a popular investment vehicle and the number of ETFs available has grown rapidly. One way to think of ETFs is as baskets of stocks, like mutual funds, but you can buy and sell them on the exchanges intra-day like stocks. Learn more about ETFs through the ETF Center, powered by Morningstar®. Once confident in your knowledge, as a Siebert client you can review our ETF Research, which includes an ETF Screener and Profiles from Interactive Data Corporation. Quickly review ETF performance data, holdings and other detailed information to help you make an informed investment decision. Logo Our method for ferreting out promising prospects.By Morningstar

Growth in the exchange-traded fund market has been explosive in recent years. It's hard to keep up with the pace of new growth, but at Morningstar, we've developed a framework to help sort through the flurry of new offerings, so we can separate the wheat from the chaff. To determine whether or not a new ETF holds promise, we ask a few basic questions.

Is It Low-Cost? The vast majority of the equity universe has already been covered by ETFs that are already on the market, so how does a new ETF get our attention?

By building a better mousetrap. For example, Vanguard Total Bond ETF (BND) and iShares Core Total US Bond Market ETF (AGG) are cheap, with expense ratios of 0.08%-0.10%. With bond funds, low expenses are essential. ETFs and mutual funds have risks, charges and expenses, and you should carefully consider such risks, charges and expenses before investing. For a complete discussion of these risks, charges and expenses, and other important information, you should read the prospectus carefully.

Is the Timing Right? ETF providers have a history of rolling out new ETFs that track the hottest markets, a practice that tends to encourage investors' worst instincts. But every market segment--no matter how hot it might be right now--will eventually fall on hard times. In fact, the hotter the category, the greater that risk. As a reality check, we try to understand how an ETF might perform in unfavorable market conditions.

For example, many alternatively weighted ETFs, such as fundamental or equal-weighted ETFs, emphasize the smaller stocks in their universes. Accordingly, these funds are likely to do well when small caps are in favor, and vice versa.

The previous examples show that casting a contrarian eye toward current market conditions can help you gauge if the time is right for a new ETF. You can also turn to the valuations of the ETF's underlying holdings as a useful guide. Morningstar's rates several ETFs based on the valuation of their underlying holdings as estimated by Morningstar equity analysts. This can help investors to uncover funds that hold large slugs of stocks that, in Morningstar analysts' views, are trading at attractive prices.

Is It a Niche Offering? Investors need to exercise extra caution when investing in new ETFs when they are niche products. A key risk is that the ETF may not behave as expected. Consider investors who rushed into United States Oil (USO) and found themselves falling far behind oil's spot-price performance.

Financial innovation is often messy; no doubt many investors in new ETFs wished that they didn't volunteer to be beta testers. You can usually avoid nasty surprises by sticking to ETFs that invest in comprehensible, traditional asset classes, such as liquid, investment-grade stocks and bonds, and by avoiding bells and whistles, such as leverage and inverse performance.

Another risk is that the ETF may not gain traction, leaving you to pay unexpected capital gains or even the ETF's shutdown costs, as in the case with one now-defunct ETF family. Finally, exotic vehicles sometimes come with exotic tax implications. Unless you want to deal with the risk of a whole new set of tax schedules to file, it might make sense to hold off until you get a sense of the ETF's tax treatment.

Is Liquidity an Issue There's also that pesky issue of liquidity. It often makes sense to let an ETF season and gain assets and liquidity. Doing so not only simplifies things for you; it's also a useful way to get a vote of confidence from the market that the ETF probably doesn't have superior competitors you may have overlooked or implementation issues.

If the underlying securities of an ETF are liquid (such as U.S. equities and large-cap developed-markets equities), expect the ETF to trade at small premiums and discounts and with tight spreads, even if the ETF itself is not that liquid. For products that hold less-liquid underlying holdings or international equities, it is more important to monitor the bid-ask spread, which shows how much the market "agrees" on the price of the ETF. Some ETFs can consistently trade at premiums, often indicating a less liquid asset class. Always, always use limit orders when buying new ETFs.

Does the Benchmark Employ a Methodology That Makes Sense? Because most major index providers have covered virtually all the equity ground, new firms seeking to find a niche in this fast-growing ETF market have sometimes taken more creative paths. Because these indexes are untested, approach them with a healthy dose of skepticism, particularly those with methodologies that include factors that are more qualitative than quantitative. To be convinced, investors should wait to see evidence that the methodology can successfully perform as expected.

Buying a new ETF doesn't have to be a nerve-racking experience. A few simple precautions, such as asking yourself whether you have a clear picture of its expected behavior and tax implications, and using limit orders, can make buying a new ETF a less costly experience.

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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