To determine when to buy an ETF, some investors use technical analysis and other tools. But you need to dig deeper.
The first question before asking when to buy an ETF is whether an exchange traded fund investment is right for your portfolio. An ETF investment is one of the most popular and most benign investing innovations of our time. ETF investments are a little like conventional mutual funds, but with two key differences.
First, ETF investments trade on a stock exchange throughout the day, much like ordinary stocks. So you can buy them through a broker whenever the stock market is open, and generally you pay the same commission rate that you pay to buy stocks. In contrast, you can only buy most conventional mutual funds at the end of the day. What’s more, commissions vary widely, depending on negotiations with your broker or fund dealer.
Second, the MER (Management Expense Ratio) is generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.
ETFs practice this “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher costs. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poors). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks change. They don’t attempt to pick and choose which stocks they think have the best prospects.
This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.
When to buy an ETF
Some investors decide when to buy an ETF with the help of technical analysis.
Technical analysis is a useful tool, but only if you recognize it as one of many tools. Before making any recommendations or transactions in client accounts, I always look at a chart. However, I don’t look at the chart for a prediction on what’s going to happen. I look to see if the pattern on the chart seems to support the view I’ve formed of the stock, based on its finances and other fundamental factors.
I find it encouraging if the two seem congruent, and they usually do. But sometimes one contradicts the other, and that’s when I know I have to dig deeper, and perhaps wait until the situation clarifies itself.
After all, there’s a large random element in all stock price changes, even ETFs, especially in the short term. When you focus on timing buy and sell decisions to improve your investment results, you are trying to come up with a system that can outguess a random factor. But a random factor is something you can’t outguess.
You can, however, offset the random factor indirectly, by taking advantage of our three-part Successful Investor approach. You can enhance our approach with a simple-but-not-easy tactic: Get used to the idea that, when you decide to include a new investment in your portfolio, you should buy while there’s still some doubt in your mind.
If you wait to buy an ETF until you are sure it will pay off for you, you’ll probably pay a higher price. You are better off to buy sooner—when you are “pretty sure,” rather than “certain.”
By the time you’re sure an ETF is a good buy, many other investors may have come to share that opinion. This is another way of saying that investor expectations have risen. That usually means the stock has used up some of its immediate potential for gain.
By buying sooner, you of course increase the risk of a short-term loss on any one investment. But our three-part Successful Investor approach automatically offsets a lot of your overall risk.
What to buy is as important as when to buy an ETF
We think you should stick with “traditional” ETFs. However, when an investment product faces booming demand as ETFs do today, investment companies try to expand sales by creating new versions of the underlying formula.
These new ETFs use a conventional stock-market index as a base, but add their own refinements. These refinements are tailored to current investor preferences or prejudices. That’s distinctly different from the traditional ETF, which simply aims to mimic an index. These newer, theme varieties may attract attention—and sales—but they frequently carry higher MERs.
In some cases, the new ETF may provide investment benefits but not consistently. In fact, it may hurt results in the long run. The worst cases are bad enough to turn investor profits into losses. One sure result is that the higher MERs will cut into the value of your ETF portfolio every year.
Another drawback to the new ETF is how much easier it is for investors to act on an urge to invest in a specific stock or stock group without doing any messy and time-consuming research. If you want to invest in oil stocks or gold stocks or Swedish stocks or wind power stocks, or any of hundreds of other stock groups, you can act on that urge. However, that may not produce the best results.
Below is a list of 6 things you should consider before buying an ETF investment:
- ETFs can be volatile, even with the diversification they offer.
- Know how broad the fund is, so you can determine its volatility. The broader the ETF, the less volatility it may have. A sector-based ETF like one that tracks resource stocks may be more volatile.
- Know the economic stability of countries when investing in international ETFs. It’s also good to mention that foreign leaders may not be your ally when it comes to passing legislation that can affect your investments
- Know the liquidity of ETFs you invest in.
- Determine if the ETFs you buy will include capital gains distributions.
- Consider buying ETFs in a lump sum rather than periodic small amounts to cut down on brokerage fees.
It’s impossible to time the market, or eliminate all risk. But you have a variety of risk-cutting techniques to choose from, and some work better than others.
How do you know when to buy an ETF? What signals do you look for? Share your thoughts in the comments below the original version of this post, as it appeared at TSINetwork.ca.
Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books.