ETFs have revolutionized the way we invest. With their low cost, ease of trading, tax-efficiency and transparency, they have surged in popularity in recent years. There are currently 1,567 exchange traded products listed in the U.S., with almost $1.7 trillion in assets under management.
ETFs now represent 15% of all trading in the market. There are some ETFs that are suitable for short-term market timing strategies. At the same time, there are a number of excellent ETF options for long-term, buy-and-hold investors. (Read: Best ETF Strategies for 2014)
What should investors consider before investing in ETFs for long-term? Here are some factors investors should look at for narrowing down to the best ETFs, of course in addition to their investment objectives.
Are Cheaper Funds Better?
Expense ratios are an important factor in the return of an ETF and in the long-term, cheaper funds can significantly outperform their more expensive cousins, other things remaining the same. (Read: 3 Biggest Mistakes of ETF Investing)
The difference in total returns between high cost and low cost ETFs (after deducting expenses) becomes very significant as we increase the holding period.
What Index does the ETF track?
Make sure that the index the ETF tracks is simple and transparent. You may want to avoid ETFs tracking exotic indexes or risky strategies, unless you are a professional trader. Similarly, ETFs with a very narrow focus—such as livestock futures—are not meant for long-term investors.
Issuer and Assets under Management
Low AUM is often one of the reasons for fund closure. Generally ETFs with less than $50 million in assets are not profitable enough for their sponsors.
Similarly, investors should look at the sponsor too. An ETF issued by a strong, profitable sponsor is less likely to shut down.
Inverse and Leveraged ETFs
They offer some excellent options for market timing and hedging but they are not suitable for long-term holding. Similarly ETFs that track futures contracts are not meant for buy-and-hold investors due to issues like contango. (Read: 3 Niche ETFs that will keep flying)
Below we have highlighted 3 excellent ETFs that are excellent for long-term holding.
Watch Your capital Grow with Vanguard Dividend Appreciation ETF (VIG)
Dividend stocks and ETFs have experienced some headwinds since the start of taper talk, but investors need to remember that dividends have accounted for more than 40% of the total returns from the market over a long time horizon and thus they should be a part of any long-term investment portfolio.
Further dividend payments are expected to continue to increase in the coming months as most large US companies have huge cash piles on their balance sheet and are in a position to increase payouts to shareholders.
However, in my view, ETFs that hold stocks with a high dividend growth potential have much better outlook compared with ETFs that focus on high dividend yielding stocks. Most high-yield ETFs focus on sectors that are likely to underperform in the rising rates environment.
VIG holds large high quality companies that have a record of increasing dividends for at least 10 years.
Current top holdings include Abbott Labs, PepsiCo, Proctor& Gamble and Coca-Cola. With its current strong focus on cyclical sectors like consumer goods/services industrials and energy, this ETF is poised to do well if the economy in general and labor markets in particular continue to improve. It has miniscule exposure to rate sensitive sectors like Utilities and Telecom.
With an expense ratio of 0.10%, this is one of the cheapest funds in this space. The dividend yield at 2.2% is not remarkable, but this fund is better suited for investors who seek long-term capital appreciation along with income and not just high current yield.
The ETF made its debut way back in 2006 and now manages more than $23 billion in assets.
VIG is a Zacks Rank #2 (Buy) ETF.
Invest like Warren Buffet with Market Vectors Wide Moat ETF (MOAT)
The term “economic moat” was popularized by Warren Buffet who said that he seeks "economic castles protected by unbreachable 'moats'.” In simple words moat is a unique competitive advantage that allows a company to outperform others in the same industry over time.
Thanks to MOAT, investors can now own a diversified group of such potential winners. Launched in April 2012, MOAT now has $600 million in assets which are invested in equal-weighted exposure in 20 least-expensive wide-moat companies. These are mostly large-cap companies with sustainable competitive advantage in their respective industries.
MOAT has highest allocation to technology sector (25%), followed by healthcare (21%) and energy (15%). With an expense ratio of 49 basis points, this product is expensive compared with two others on this list, but with its excellent investment strategy, it is poised to deliver solid returns to investors.
The index strategy has worked in the longer term. In five years through December 2013, the Moat index had an average annual return of 22.72% versus 17.94% for the S&P index. The ETF has also beaten the broader market since inception.
Schwab U.S. Large-Cap Value ETF (SCHV)
Numerous academic studies have shown that value stocks have delivered higher returns with lower volatility compared with growth stocks over the long term in almost all the markets studied. Given their proven performance over long term, value stocks and funds should be a predominant part of any ‘core’ portfolio.
SCHV provides broad exposure to large-cap U.S. stocks with value style characteristics. Launched in December 2009, the fund has so far been able to attract assets worth $713.4M, which are invested in 356 holdings.
With an annual fee of just 7 basis points, this product is the cheapest option in the large-cap value space. Additionally, the dividend yield at 2.3% is quite attractive. Financials (24%), Consumer Staples (11%), Energy (11%) and Consumer Discretionary (11%) are the top four sectors, the fund has invested in.
SCHV is a Zacks Rank #2 (Buy) ETF.
Investment advisers often warn--“don’t fall in love with a stock”. Does that apply to ETFs as well? Usually not, since ETFs with their diversified holdings eliminate company-specific risk to a large extent.
ETFs discussed above are excellent options for buy-and-hold investors. There is nothing not to love about them.
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