Exchange-traded funds are a popular choice for investors who want both tax efficiency and cost-effectiveness. In the U.S. alone, ETF assets under management are expected to total $4.2 trillion by the end of 2020, growing about 15 percent, on average, each year.
[See: 7 of the Best ETFs to Own in 2017.]
The 2016 Trends in Investing Survey, by the Journal of Financial Planning and the Financial Planning Association Research and Practice Institute, found that 83 percent of financial advisors currently use or recommend ETFs to their clients. Approximately one in four investors has ETFs in a portfolio, according to BlackRock’s ETF Pulse Survey, with millennials more likely than other generations to embrace these investments.
Although they’re a low-cost alternative to traditional mutual funds for diversifying a portfolio, ETFs are like any other investment in that sometimes you’re better off selling sooner.
A new strategy that isn’t a good fit. Although it’s uncommon, an ETF can shift its underlying strategy and even change its benchmark over time.
Gabriel Pincus, president and portfolio manager of GA Pincus Funds in Dallas, Texas, says investors should consider how much that change might affect their portfolio’s diversification.
“Since ETFs are based on an underlying index, these strategy changes involve switching the underlying index upon which the ETF sits,” Pincus says. “It’s very rare that the focus or strategy change will be enough of a reason for an investor to sell their holdings in favor of a different ETF.”
He points to the iShares Core Russell US Value ETF, now called iShares Core S&P US Value ( IUSV), which changed its underlying index from the Russell 3000 to the Standard and Poor’s 900 Value index in January 2017. The change eliminated small-cap stocks from the ETF’s benchmark, shrinking the total stocks tracked by 10 percent. The fund’s composition also became slightly more conservative as a result.
Pincus argues that this type of change would affect an investor’s overall diversification minimally. If you’re concerned about maintaining your exposure to small-cap stocks, however, you’d have to consider how well an ETF making such a change would continue to fit your larger investment strategy.
Higher fees without better returns. Although ETFs are designed to minimize cost, you should still pay attention to what you’re paying for the returns you’re earning.
“Many ETF expenses range, as will their performance,” says Adam Vega, a certified financial planner with United Capital Financial Advisers in Fort Lauderdale, Florida. “Costs play a large part in the attractiveness of an ETF, and although most are built to track an index, they never track perfectly.”
[See: 7 Ways to Pay Less for Your Investments.]
It’s also important to look at whether an ETF seems to grow more expensive over time. “Rising fees are a red flag, as fees are generally declining for ETFs,” says Daniel Kern, chief investment officer for TFC Financial Management in Boston, Massachusetts.
If you’re paying more for a specific ETF, analyze the reasons for the higher cost.
“As with strategy changes, the argument for the fee increase would need to be quite convincing,” Kern says. “The easiest way to validate the need for a fee hike is to compare fees among similar ETFs. If the ETF that’s raising fees still offers reasonable value relative to competing ETFs, it might make sense to stay invested.”
On the other hand, if the fund’s performance isn’t keeping pace with rising fees, then it may be time to move on to another investment. Vega says establishing a line in the sand can help you better manage your ETF position in your portfolio when you’re in doubt about whether to cut your losses or stick it out.
“Say your ETF has a 20 percent gain, should you sell it? Or if there’s a 10 percent loss, should you sell it? If you can’t afford a 20 percent loss to your portfolio, you shouldn’t be taking on that 20 percent level of risk,” Vega says.
Performance that doesn’t match the benchmark’s. An ETF’s objective is to track a specific market index, but that doesn’t mean the fund consistently mirrors the index’s returns. That’s where tracking error comes in.
“Tracking error is the relationship between the performance of an ETF and the benchmark that it’s trying to replicate,” says Matt Gulbransen, owner of Callahan Financial Planning Corp. in Minneapolis, Minnesota. “If you own an ETF that’s tracking the Standard and Poor’s 500 index, for example, you’d want the tracking error to be minimal.”
Ideally, says Gulbransen, investors would evaluate an ETF’s tracking error before investing. If that’s something you overlooked, however, you should still consider how a fund’s tracking error correlates to the index you’re trying to match.
Jimmy Lee, CEO and founder of The Wealth Consulting Group in Las Vegas, says if an ETF’s performance doesn’t mimic its index, that could be a good reason to sell, but don’t sell just because you’re losing money.
“Take into consideration why you bought the ETF, the time horizon for investment, expenses, the management team who runs the ETF and whether there are alternatives that may be more suitable for your investment objective before making a move,” Lee says.
A lack of liquidity. Although it doesn’t happen often, if an ETF’s liquidity shrinks, so could its profitability.
“A lack of liquidity is a problem if an investor needs to sell an ETF and it doesn’t trade enough shares to get the appropriate price,” Lee says. “In this case, an ETF that lacks sufficient liquidity could be sold at a share price that’s lower than it should be during a time with market volatility.”
Considering how large your position is in a particular ETF can help you determine whether a lack of liquidity risks hurting your portfolio.
[See: 10 Long-Term Investing Strategies That Work.]
“As an investor, if you’re worried that your holding will represent too large of a portion of the ETF, you should stick with a fund where your investment is less than 0.5 percent of the market value of the ETF,” Pincus says. “If the outstanding shares of the ETF shrink to the point where you own more than one percent of the ETF, you should consider trimming your holdings.”
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4 Signs That It’s Time to Sell an ETF originally appeared on usnews.com
