Morningstar ETF Strategist John Gabriel: Identifying the investment thesis is key to the right ETF

Encompassing a wide variety of investment objectives, running the gamut from global equity to sector offerings, it is undoubtedly a challenge to pick the right ETF. We consulted John Gabriel, Morningstar ETF Strategist, to figure out how investors can go about choosing a suitable ETF for themselves.

Jessie Yung 07.10.2011
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ETFs made its debut in Hong Kong a decade ago.  Launched in late 1999, the Tracker Fund of Hong Kong (TraHK) became the first ETF to track the Hang Seng Index.  Unlike the usual ETF, TraHK was the indirect result of Hong Kong authorities’ efforts to ward off speculators led by George Soros in 1998.  To prevent the speculation on the Hong Kong dollar and its equities following the Asian financial crisis, the government acquired HK$120 billion worth of blue-chips over 2 weeks in August 1998 by using its forex reserves.  Post the operation, stocks acquired were subsequently disposed in a systematic manner with the creation of the TraHK, the largest IPO in the Asia ex Japan region at its time of launch.  Despite TraHK’s success, ETF choices remained very limited for retail investors until 2009.  Nearly half of the ETFs listed on the Hong Kong Stock Exchange (HKSE) were launched over the past two years.

 

Till end of August 2011, there are around 80 ETFs listed on HKSE.  Encompassing a wide variety of investment objectives, running the gamut from global equity to sector offerings, it is undoubtedly a challenge to pick the right ETF.  We consulted John Gabriel, Morningstar ETF Strategist, to figure out how investors can go about choosing a suitable ETF for themselves.

 

Balancing risks and needs

 

Gabriel pointed out that investors are often too quick to ask “which ETF should I buy?”  He stressed, “The search for the right ETF cannot begin until the investor has a good understanding of the type of market exposure they are seeking as well as how the ETF will interact with the rest of the investor’s portfolio.”

 

Assessing the risk tolerance of an investor in the context of the investment thesis is another essential aspect to selecting the appropriate ETF.  For example, if an investor’s risk tolerance is relatively low, it may not be a suitable for them to invest a large percentage of their portfolio in emerging markets (given the higher volatility) even if they believe emerging markets will outperform.

 

Even if the risk of an ETF corresponds with their risk tolerance, investor should not forget the importance of diversification when building a portfolio.  If the target ETF is highly correlated with current portfolio holdings, it may not be prudent to add it to the portfolio from the risk management perspective.

 

‘Good’ or ‘bad’ is relative

 

There are no inherently “good” or “bad” ETFs, Gabriel noted.  “There will be many situations where an ETF is ‘good’ for one investor but unsuitable for another.”   He suggested investors to look for four elements when deciding amongst the various ETF offerings:

 

1. Competitive fees: Bear in mind that ETFs are passive index-tracking vehicles. Unlike an actively managed fund, the stock picking and the depth and breadth of research are not applicable.  Hence, the management fees of ETF should be much lower than their mutual fund counterparts, given the lower overheads.

 

2. A strong track record of closely tracking the benchmark index: A major characteristic of passive ETFs is their ability to track the performance of the underlying index.  The performance of a passively managed ETF should be judged on their ability to replicate an index’s performance.

 

3.  Tight bid-ask spreads: Gabriel noted that the bid-ask spread is a reflection of an ETF’s liquidity, and represents the cost of buying or selling an ETF.  Tight bid-ask spreads indicate higher liquidity and lower transaction costs.

 

4.  The benchmark is appropriate: Gabriel emphasizes that “If the index that an ETF is tracking is not ‘good’, then the ETF will not be ‘good’ either.”  In other words, an investor must be comfortable with the ETF’s underlying index, and how it was constructed and calculated in order to evaluate the merits of the ETF.

 

Remain conservative amidst the current volatility

 

When asked about which ETFs might present more value in the current volatile environment, Gabriel recommended a focus on capital preservation.  “There are many risks in the global economy that have the potential to weigh on stock market returns.  As such, we currently favor defensive sectors such as consumer staples, healthcare and utilities.  In terms of geographical regions, we still like the emerging markets. Emerging market economies have excellent growth prospects, a burgeoning middle class, and younger populations.  Along with prospects for much faster GDP growth than the developed markets, the emerging markets also tend to be far less indebted as compared to developed economies.”


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