ETF Terms That Will Take Your Knowledge to the Next Level

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It’s official: Exchange-traded funds (ETFs) have become one of the most sought-after investment vehicles on the Street.

In a 2015 survey by the Journal of Financial Planning and the FPA Research and Practice Institute, ETFs emerged as the most popular investment among financial advisers, with 8 in 10 currently using or recommending them to their clients—double the number from 2006.

So chances are, you may already be investing in ETFs—but how much do you really know about them?

Sure, you may get that they’re trying to track an index or cover a specific sector or region of the world. But it’s always wise to take a look under the hood and have a deeper understanding of what’s in your portfolio.

So to help you get smarter about some of the ETF lingo you may hear being tossed around, we’ve compiled a checklist chock-full of need-to-know terms that can help you take your ETF knowledge—and investing—to the next level.

Know Whether Your ETF Is Passive or Active

Passively managed investments seek to track a stock or bond index in an attempt to try and replicate that index’s performance, which is why this strategy is also often referred to as index investing.

A passively managed ETF, for instance, might hold stocks of companies in the S&P 500 in an attempt to mirror the performance of the S&P 500 index as a whole.

“In many ways, passive investing and ETFs have become synonymous,” to the extent that the majority of ETFs seek to track an index, says Ben Johnson, director of global ETF research for investment research firm Morningstar. “There’s not a team of people out there who are looking to decide which stocks are going to go up and which are going to go down.”

Actively managed investments, by contrast, require portfolio managers to make decisions on which securities to buy and sell, often in hopes that their fund will outperform the market, depending on the objective of the ETF. Actively managed ETFs, however, are far less common than index ETFs. Signs an ETF may be actively managed? Its name or description focuses on a specific investment strategy, rather than on the benchmark or index it is seeking to replicate. It may even incorporate the words “active” or “managed” in its name, though not always.

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Know What Your ETF’s Expense Ratio Is

The expense ratio is the percentage of your average net assets that your ETF provider charges to help cover operating expenses. If you have an annual expense ratio of 1%, for example, that translates to paying $1 in operating costs for every $100 in assets.

Because actively managed funds require more administrative overhead, they tend to have higher expense ratios than passively managed index ETFs. These costs can eat into your returns, so it’s important to compare different ETF providers’ expense ratios before choosing which one to go with. Remember, also, that fees can vary by provider as well as by fund type.

For example, an ETF that seeks to track a broad index like the S&P 500 will usually cost less than a more targeted fund, like one focused on emerging markets. On the lower end of the scale, a fund provider might charge less than two-tenths of a percent.

Know How Liquid Your ETF Is

You typically associate the word “liquidity” with how much cash you have on hand at any given moment. In the ETF world, however, liquidity refers to how frequently a given ETF’s shares trade throughout the day.

Generally, the ETFs that seek to track major indexes are more liquid than the narrowly focused ones, because so many more investors are interested in buying and selling those shares, says Ed Gjertsen, president of the Financial Planning Association and vice president of Glenview, Ill.–based Mack Investment Securities.

A large index ETF, for instance, could trade millions of shares a day. Meanwhile, there are ETFs that, “if they trade 100 shares a day, that would be a big day for them,” Gjertsen adds. “They may rarely trade because there’s not a lot of people who follow them. When you start getting into really narrowly focused ETFs, you run the risk of liquidity issues.”

So why is liquidity important?

The less liquid an ETF is, the harder it may be to sell its shares—which can put you at risk of a less favorable bid-ask spread, or the difference between the asking price for a share and what a buyer is willing to pay for it. So it’s worth checking an ETF’s average daily volume on a research site like Morningstar.com to see if it has the kind of liquidity you want.

Know What Type of Exposure Your ETF Offers

Exposure is used to describe the various corners of the market that you’re accessing in your portfolio via your investments, and the vast number of ETF offerings available help make ETFs a valuable tool in diversifying your investments, says Gjertsen.

“The word ‘exposure’ could be used in line with diversification,” he adds. “That’s one of the things I enjoy about ETFs as an adviser—they give me a tremendous tool to be able to invest in [different parts of the market].”

For example, investing in a China large-cap index fund could give your portfolio more exposure to emerging markets—and, more specifically, to markets in China. Investing in a biotechnology index fund could give you exposure to both the health and technology sectors.

The types of exposure you want for your portfolio will depend on your individual investing goals, but novice investors will likely want to start broad, Gjertsen suggests.

“Somebody who’s been investing for a longer period of time may have a good understanding of sectors and how the markets operate in terms of liquidity,” he says. “But I wouldn’t encourage relatively new investors to start diving deep into a single-strategy, narrowly focused ETF, because you have to understand the inherent risks.”

Know What Your ETF’s Tracking Error Is

Tracking error is the difference between the performance of the ETF and that of the target index it is tracking, essentially helping the investor to know how closely the ETF mimics its intended benchmark.

For instance, “if you want to invest in an S&P 500 index fund or ETF, you want to make sure that fund is tracking the S&P 500 index with a high degree of precision and fidelity,” Johnson says. “The tracking error gives you one measure by which to gauge how well your ETF is delivering on its promise to track an index.”

For ETFs that track highly liquid, major indexes, tracking errors tend to be relatively minimal—typically only tenths or hundredths of a percent.

When an ETF seeks to track more niche indexes, however, there’s the potential for greater tracking error. If an index holds securities that trade less frequently—such as high-yield bonds or emerging-market equities—the fund may incur higher transaction costs to buy those securities. These costs could eat into the total return, thereby increasing tracking error.

Investors can find an ETF’s tracking error on sites like Morningstar and Zacks.com.

Know If You’re Investing in a Smart-Beta ETF

Smart-beta ETFs, sometimes known as factor ETFs, are a category of ETF that weighs companies using different standards of performance from those that are used to track the big, traditional, capitalization-weighted indexes.

For instance, rather than track an index based solely on market capitalization, a minimum-volatility ETF may track companies that experience smaller stock-price swings. A quality ETF would tend to invest in firms that appear to be more financially healthy. A value ETF might focus only on companies whose stock prices appear to be undervalued by the market at large.

Because smart-beta ETFs may have higher fees than those that track plain-vanilla indexes—though likely smaller fees than actively managed ETFs or mutual funds—it’s important for investors to carefully evaluate how these ETFs fit into their portfolio before taking the plunge.

“For smart-beta ETFs, it’s important to understand what the manager is trying to accomplish through the fund,” says Gjertsen. “But it gives you other criteria to look at and ask, ‘Does this fit within my overall portfolio?’ ”

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