Brian Donovan has spent his investing career crunching numbers to really understand the value of individual companies. So when the chartered business valuator and founder of StockCalc agreed to share his thoughts on exchange-traded funds (ETFs) – investment vehicles that let you hold a collection of stocks and bonds all at once – we listened up.

“I don't believe I'm a typical investor. I am very heavy into [individual] stock selection based on my background. But sometimes I find it quicker and easier to select an ETF, especially for pure sector or industry plays," he says. “I don't always have the time to research, you know, 60 companies." Having said that, his company evaluates 9,000 stocks and 2,000 ETFs ​daily using valuation models.

That simplicity is just one reason ETFs are surging in popularity, particularly among new investors. These days ETFs span seemingly every theme and industry you can think of, from ESG to e-sports, allowing investors to pursue diversification and growth on their own terms. With relatively low fees, ETFs are also considered cost-efficient. (More on that later!)

Last time we spoke with Donovan, he discussed in-depth techniques for finding the value of individual stocks. This time, we wanted to find out about Donovan's personal approach and considerations when selecting and evaluating ETFs.

First, a word on ETFs and risk

ETFs require investors to think holistically about risk. They are often designed with instant diversification in mind, giving investors of every investing style exposure to several underlying asset classes and companies. But “there's a misconception that ETFs are all low-risk because they spread out that risk across many holdings," says Donovan. “In fact, you're not taking on less risk – you're assuming all of the risk of each underlying company."

Consider a fund that holds five similar financial institutions, Donovan says. Its performance is not dependent on any single company, but the fund as a whole will move with the financial industry's ups and downs. You can spread that risk around with a fund holding five different companies from five different industries, but even then, that ETF's performance may be tied to a regional market. Allocate across a mix of geographies with companies from the Americas, Europe and Asia – and, well, you get the picture.

“The theory behind that is, if you own a number of different stocks, you're spreading out your risk as long as they're not all doing the same thing," says Donovan. “ETFs require the same thinking."

4 things to know when researching ETFs

Investors can generally take a “top-down" or “bottom-up" approach to researching ETFs, says Donovan. Top down means starting with a wider category — say, a region or broad market index like the S&P/TSX 60 — and gradually narrowing the scope of your search by country or sector, through to underlying stocks and performance. A bottom-up approach involves researching individual companies or assets you're interested in, then finding an ETF with the desired mix.

For investors looking for a specific type of ETF, or simply hoping to explore, screeners can also be a helpful tool. These handy curated lists can be found by clicking ETF Screener in the Research tab at the top of the RBC Direct Investing online site.

Whatever your chosen method, getting familiar with the terms below can help you pick ETFs that fit your portfolio and better compare them against their peers.

Underlying stocks and assets

An ETF's detailed quote page shows you its top 10 underlying holdings — that is, the stocks that make up a fund — under the "holdings" tab, as well as what percentage of the fund each constitute. A comprehensive list can often be found on an ETF provider's website. This information is key to understanding how a fund is structured.

As with individual stocks, Donovan considers where we are in the economic or business cycle and what that can mean for investors when researching ETFs. The thinking goes that when interest rates rise, bond yields generally follow suit — at the same time, stocks tend to decrease in value as businesses and investors cut back spending, and bond prices fall. When interest rates head in the other direction, however, investors can expect to see the opposite effect. Knowing this (though it’s a theory – not a hard and fast rule), investors can balance their portfolio by asset class to take advantage of economic conditions.

Some ETFs are weighted by asset class – listing percentages of equities, bonds, cash and more – allowing an investor to select a mix they feel is appropriate to their needs (say, a traditional 60/40 split between stocks and bonds). Certain ETFs actively manage this balance, while others stick to a set allocation.

Management expense ratio (MER)

After researching ETFs and their underlying stocks, you may notice some ETFs – the ones tracking major indexes, for example – have very similar holdings. What to do? "If they are identical, or close to it, next I'm looking at management expense ratio and performance — how they have done," says Donovan.

If two ETFs' holdings are similar, explains Donovan, their performance should be the roughly the same, too. That makes management expense ratio (MER) a key differentiator. MER, commonly expressed as a percentage, is the annual fee that all funds charge shareholders for holding the fund. Over time, the accumulated cost of MERs can have a significant effect on the performance of your portfolio.

Donovan's thinking? If two funds have similar holdings, and similar performance, but one costs you more, well — "That would tend to be the factor that would really take you one way or the other."

Performance

Donovan's other comparison metric is performance. While a fund's past performance is not a reliable predictor of its future performance, it can help an investor see how similar funds react differently to market pressures.

Donovan begins by comparing their performance, side by side, in one-year chunks for as far back as data is available. "Don't let one year of performance — or even one period of performance — sway you," cautions Donovan. "Look at the big picture."

If an investor knows what happened in the markets in a given year, “you quickly spot the differences — where certain sectors, or interest rates, or geographies have come into play."

Beta

Investors attracted by the perceived stability of ETFs should pay attention to their beta, says Donovan. Beta is a commonly used measure to indicate the risk of a particular investment, and can be found on an ETF's detailed quote page. In practical terms, a beta above one generally means that a security is more volatile than the overall market; a beta below one can indicate it is less volatile.

"If you are comparing and contrasting funds, all things being equal, if one has a higher beta, it's going to feel good on the upside, but it's not going to feel so good on the downside," says Donovan — so you may want to consider how you react to market volatility when making a decision.

How to evaluate an ETF

Digging deep into a fund's fundamentals can give investors an even stronger understanding of its value. While there are many analysis techniques out there, Donovan focuses on these.

Compare an ETF against its industry

When evaluating an ETF focused solely on one of the many sectors that make up the markets, like technology or utilities, Donovan offers a little shortcut.

“Theoretically, [a sector-specific ETF] should give you roughly the same result as the sector average," says Donovan. “There are better and worse companies within a sector, of course, but everything that's affecting the sector should affect funds in relatively the same way."

You can run a simple valuation by comparing a fund's price-to-earnings ratio, or P/E ratio, found on its detailed quote page to the P/E ratio of its corresponding industry. (The latter can be found by hovering over the Research tab at the top of the RBC Direct Investing online site, then clicking Sectors & Industries.) This comparison can give an investor a basic idea of whether the ETF is over or underperforming its industry.

Calculate a fund's intrinsic value

Another approach to choosing an ETF starts with determining its real — or intrinsic — value to see if it represents a possible "buy low" opportunity. This is the basis of fundamental analysis.

Donovan explains how to perform fundamental analysis on individual stocks in our previous interview with him. Determining the value of an ETF, he explains, can be straightforward — if a little time-consuming — and requires estimating the future cash flow of not just one company, but all companies that make up a fund.

Here's what that could look like for an ETF made up of Company A, Company B and Company C:

1. Refer back to a fund's holdings and calculate the intrinsic value of each underlying stock using the well-known, but powerful, Discounted Cash Flow equation. Donovan outlines how to do that here.
2. Multiply the intrinsic value of each stock by the percentage of net assets it constitutes in the ETF.
3. Add the results together. This provides an estimate of the ETF's intrinsic value as a whole.
4. Donovan compares this final result to the ETF's current price to determine if it seems over or undervalued.

For illustrative purposes only.