Comparing ETFs? Don’t Just Look At Expense Ratios

The rule when buying ETFs is that when all things are equal, buy the one with the lowest expense ratio. But remember that similar sounding ETFs often aren’t equal. This means don’t let the expense ratio be the only factor in choosing an ETF.

“Our belief is expenses and past performance matter, but more important is understanding what’s inside the portfolio,” said Todd Rosenbluth, S&P Capital IQ director of ETF research.

SPDR S&P 500 ETF (SPY) tracks the S&P 500 stock index and charges a tiny expense ratio of 0.09%, commonly called nine basis points. One hundred basis points make up 1 percentage point. Guggenheim S&P 500 Equal Weight ETF (RSP) also tracks the S&P 500. But it charges a fee of 0.4% of assets.

Look At The Performance

“You might ask ‘Who in their right mind would pay 40 basis points vs. 9?'” said Ron Delegge, founder of ETFguide. “But then you take a look at the 10-year return.”

RSP returned an average annual 9.42% in the past 10 years, compared with 7.85% for SPY, according to Morningstar. In fact, RSP beats SPY in all periods reported on Morningstar.com, from one month on.

The big difference between the funds is the way the indexes are weighted. SPY follows the S&P 500’s classic market-capitalization weighting, which multiplies the stock price by the number of shares outstanding to get a stock’s market value. The biggest companies get a larger weighting, comprising a greater percentage of the index than the smaller ones. Thus a $1 move in Apple (AAPL), with a 3.98% weighting, will lift or drag down the index much more than a $1 move in the shares of Diamond Offshore Drilling (DO), which has a weighting of just 0.01%.

But RSP gives every stock in the index an equal weighting of 0.2%. This means a $1 rise in Diamond Offshore’s stock moves the index just as much as a $1 increase in Apple’s shares. By giving greater weight to the smaller stocks in the index, this has a big effect on the fund’s performance. Year to date, RSP is up 2.25% vs. SPY’s 1.29%, 96 basis points more — after paying the expense ratio.

“Would I be willing to pay more for those returns?” asks Delegge. “Definitely.”

Of course, SPY could just as easily outperform RSP in periods when the market favors large-cap stocks or other factors that can be found in SPY but not RSP.

But S&P 500 trackers aren’t alone. “One example that is much maligned is PowerShares FTSE RAFI U.S. 1000 ETF (PRF), said Michael Krause, president of AltaVista Research in New York, which runs the ETF Research Center website. “I calculate that cumulative since its inception in 2006, PRF has outperformed iShares Russell 1000 ETF (IWB) by 14 percentage points.”

ETF Research Center pegs PRF’s average annual return since 2006 at 8.9% vs. 8.1% for IWB.

PRF’s expense ratio is 0.39%, while IWB charges 0.15% of assets.

Not Alone

This trend happens a lot among the industry ETFs. SPDR S&P Homebuilders ETF (XHB) and iShares U.S. Home Construction ETF (ITB) sound like they track the same industry, meaning they should post similar results. XHB charges 0.35%, while ITB charges 0.45%, so XHB seems like a better choice.

Yet only 35% of the XHB holdings are actual homebuilding companies, and 28% building products. The rest of the stocks are home furnishing producers and retailers, home improvement retailers and household appliance makers. However, homebuilding companies make up 71% of the ITB portfolio, with building products at 13%.

ITB has risen by an annual average of 25.72% in the past three years vs. 21.01% for XHB. Year to date, ITB is up 8.32% vs. XHB’s 6.74%. That more than compensates for the extra 10 basis points.

“Cheaper hasn’t been better as of late,” said Rosenbluth.

Originally published in Investor’s Business Daily.

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6 Cult Stocks to Buy and Sell

Mythic status is typically reserved for sports heroes and Oscar winners, but lately a bunch of stocks have acquired the mantle. These issues are sitting on astronomical price gains and have a cult-like devotion among their followers, I mean, shareholders.

You know the type: true believers intent on convincing you their company is changing the world and destined to grow forever. With a religious fervor, they tweet and blog and paint Facebook walls to defend their investments. It’s no surprise cult stocks are the most dangerous kind to sell short (try to profit from a falling stock by selling borrowed shares with the intention of buying them back for less).

That’s not to say these companies don’t deserve special status. “They become cult stocks because they pass the uniqueness test,” says R.J. Hottovy, Morningstar’s director of consumer research. This comes from creating a unique product or retail or food-service concept. Some are fads, like Crocs, and blow up fast, taking late-arriving speculators for every last dollar. Others succumb gradually to knockoffs, changing tastes, or some rival’s better technology. But enough develop their brands into icons and accumulate immense financial firepower.

No wonder, then, that such companies’ shares don’t just appreciate steadily. They soar far beyond what is realistic if you link the stock to fundamentals such as the profit margin or the earnings growth rate. Eventually, it gets tough to reach ambitious targets for year-over-year sales and earnings growth. But in a market starved for stories, who is to say a cult stock cannot go ever-higher on momentum?

So we decided to study six to see if the business remains on the cutting edge and if their devotees still drink the Kool-Aid. (All prices and stock-related data are as of March 16.)

Apple (AAPL, $330.01)

It’s no shock that the king of the cult stocks is Apple. Whenever Apple launches a new product — think iPod, iPhone, iPad and iTunes — it changes the consumer electronics industry and a lot of others, including Wall Street. As we pass the two-year anniversary of when the stock market bottomed in early March 2009, Apple stock has more than quadrupled from its 2009 low of $78. The Standard & Poor’s 500-stock index only doubled.

While Apple’s product lines have seen phenomenal growth, Apple only owns a small share of its growing markets. The iPhone holds 16% of the global smart-phone market, and the Mac claims less than 5% of the world’s personal-computer volume. Apple shares trade at just 15 times this year’s earnings estimate, almost a five-year low for the price-earnings ratio. Compared to the S&P 500’s P/E of 15 times 2011 estimates and 23 for big tech stocks, Apple actually looks cheap. We rate it BUY

The other five cult stocks are Netflix (NFLX), Amazon.com (AMZN), Priceline.com (PCLN ) Chipolte Mexican Grill (CMG) and Polo Ralph Lauren (RL).

For the full article go to Kiplinger.com or if you prefer go to the slideshow for this article.