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A Return Performance Worth Watching

Assessing ETFs

Whether you’re considering a new investment or deciding whether to hold or sell a security, performance is a key element in decision-making. In evaluating returns, however, it’s essential to know what you’re looking for. That’s just as true for exchange-traded funds as it is for individual stocks.

The underlying rule of thumb is that the return an ETF provides is directly related to the risk it poses, which is also the case with individual investments you make. Investments with the highest potential return invariably expose you to the greatest risks, including the potential loss of principal.
If an ETF’s record extends through at least one full market cycle, its returns over that period can give you a sense of its volatility, which affects its potential for gains and vulnerability to losses in different phases of that cycle. This information also helps you anticipate reasonable expected returns.

How To View Performance

In most cases you can evaluate an ETF’s performance by looking at its percentage return. It’s calculated by adding the change in the ETF’s value over a specific period to any dividends or interest it has paid. Fees and expenses are subtracted, and the total is divided by the amount invested.
Monitoring the performance of your ETF holdings is relatively easy. You can find percentage return online by checking the fund sponsor’s website, general financial websites and ETF rating services. Returns for various time frames are computed using information the sponsor provides. Results for periods longer or shorter than a year are annualized. (If you compute your own return, you’ll probably find it varies somewhat from the return that’s reported largely because of the timing of your purchase or sale of shares.)
An ETF’s performance is based primarily on that of the underlying investments as reflected in the index to which the ETF is linked. For example, you can expect the return on the SPDR vehicle tracking the S&P 500 index to reflect the index’s changing value. Similarly, a gold or oil ETF tends to echo what’s happening with that underlying commodity in the spot, or cash, market. The ETF’s value increases as the commodity’s current price increases and drops if the commodity’s price drops.
Although the underlying investments are a big part of the story, they aren’t the whole story. The combined effect of fund expenses and management practices, such as how — and how quickly — the ETF reinvests cash from dividends and capital gains, means that the return on an ETF varies from the return of the index it aims to duplicate.

Tracking Errors

The gap between index performance and index fund performance is known as tracking error. The smaller the difference, the happier investors and analysts are. After all, you choose an index-based product over an actively managed one to achieve the same return as the index.
In seeking the smallest possible tracking error in a fund category, you can start by comparing the fees and expenses for funds that track similar market segments. You can get a snapshot of these costs by looking at a fund’s expense ratio. That’s the annual percentage of your fund assets subtracted from your account before return is calculated. Overall, the average is 0.52 percent.
You’ll also want to check any other factors that might affect return. For example, an ETF that tracks an index whose components change frequently may have a higher tracking error because its trading costs, which aren’t included in the expense ratio, are higher than those costs for a comparable ETF.
In the United States, a particular index often is tracked by only one ETF. As a result, you can’t compare the returns of multiple investments to a single relevant index, as you can with stocks or actively managed mutual funds.
But what you can do is look at all the ETFs in a particular segment. For example, if you’re interested in an ETF tracking U.S. large-capitalization stocks, you can study the returns and tracking errors of ETFs from major providers that offer such a fund — and most do.
Although the ETF portfolios vary since they’re paired with different indexes, such as the S&P 500, Russell 1000 and so on, and include different numbers of stocks, there’s still significant overlap, especially of the largest companies. As a result, this approach can help you identify the ETF with the strongest record over time — remembering, though, that history doesn’t assure future performance.

Back Testing

Also keep in mind that some ETFs follow newly created indexes that don’t have a track record. In this case the sponsor may use back testing. This process involves computing and combining the past returns of the index components to create a performance history that assumes the fund had traded over a particular period. The sponsor’s choice of time frame can influence the results, and trading costs are typically omitted in constructing hypothetical returns.
Although performance isn’t the only factor in making an ETF decision, especially if the fund doesn’t have a long history, it’s a valuable tool in assessing whether the ETF belongs on your short list.

Virginia B. Morris is the Editorial Director for Lightbulb Press.

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