With an abundance of ETFs in the market place and it can be hard to differentiate between them.
ETFs can take different approaches to replicating an index and their quality can vary on many measures.
Taking a simple checklist approach can help sort out the quality ETFs that best match portfolio needs.
The rapid increase in the number of exchange traded funds (ETFs) in the marketplace in recent years has made the task of navigating the landscape relatively daunting. Selecting an ETF from the sizeable universe can be time consuming and overwhelming. Knowing what you own is an important investment principle regardless of whether you are buying a security, managed fund or ETF.
This series of simple questions can help you create a thorough framework for your analysis to help ensure the ETFs you choose best meet your needs.
It’s the simple questions about what ETFs own, how they work, and who manages them that help you find the ETF that suits your needs.
Evaluate the Actual Index
Does the index and/or fund objectives align with your portfolio?
Some checklist questions:
How long has the index existed?
New indices are created almost every week. An index provider’s tenure in the marketplace can indicate a measure of stability.
Is the index concentrated in particular sectors, companies of countries?
Understanding an index’s focus allows you to pinpoint the exact exposure you need for a portfolio.
What is the index or ETF weighting methodology (how the index decides how much of an asset or security to hold)?
Different index weighting methodologies lead to differences in performance, and risk/return characteristics, even compared to seemingly similar indexes.
Weightings can be based on:
Does the index report holdings on a daily basis?
The more frequently the index reports holdings, the greater the transparency, and the easier it is to determine how closely the ETF tracks its index.
How often is the index rebalanced?
Rebalancing is when the index adjusts to match the market changes since the last rebalancing. If the index frequently adds and removes holdings, those decisions can impact funds that tightly track the index by changing market exposure and increasing trading costs, which reduces investors’ returns.
Examine the ETF Structure
Does the ETF’s structure help reduce portfolio risks and promote liquidity? Some checklist questions:
How many stocks or bonds are in the index, and what are the fund’s diversification guidelines?
A greater number of holdings mean increased diversification benefits for the portfolio.
What is the investment approach? How does the fund replicate the performance of the index?
Not all ETFs are created equal. ETFs can employ a full replication, optimisation-based, synthetic replication, or an active management approach to govern portfolio construction and trading decisions. These different approaches dictate how closely a fund tracks its index – and how well the fund suits a given portfolio.
What are the fund’s top holdings?
Having a large portion of the fund invested in a handful of holdings can lead to concentration risk.
Do the ETF holdings make sense in terms of the objectives of the fund?
The names of some ETFs can confuse how they actually invest. It’s necessary to look beyond the fund’s name, and the index it tracks, and examine the underlying holdings to understand the fund’s risk/return profile and judge whether it adheres to its stated objective.
Do the index holdings, or its strategy, overlap with existing strategies already in your portfolio?
Significant portfolio overlap can leave investors over-exposed to various sectors, companies, or issuers; or underexposed to the important core markets.
Does the ETF follow a traditional market capitisation weighting scheme, or is it equal weighted?
A market capitalisation weighting might be ideal for a broad market, energy or financial services sector fund while an equal weighting that doesn’t allow large cap names to dominate the index might be better suited for a thematic ETF, like natural resources.
What are the ETF’s assets under management?
Significant assets illustrate investor interest and, although products’ break-even points vary, a commonly recognised asset level at which an ETF becomes sustainable is around $50 million, a level not matched by almost half of today’s ETFs. Greater assets under management can also enhance a fund’s liquidity.
What type of fund is the ETF? Unit Investment Trust, Open-End Fund, Grantor Trust, or Exchange Traded Note?
The different types of product structures used by ETFs can lead to differences in how the products are managed and taxed, as well as how they control risk and promote liquidity in portfolios.
If the ETF lends securities, what is the collateralisation process, and how is it managed?
Income from securities lending could reduce fund expenses. Understanding the collateralisation process can help you assess potential risk.
Are there redemption fees?
Redemption fees encourage buy and hold investing, thereby reducing a fund’s expenses.
How well does the ETF track its benchmark?
With an ETF that seeks to track the performance of an index, ideally, the fund should tightly track its index. How well it tracks is compared on the basis of tracking error, and tracking difference.
What is the difference over time between the fund’s return and the index’s return?
The difference between the return of a fund and the index it tracks is called tracking error. This just measures the deviations of the fund from the actual performance that arise from how funds replicate and rebalance. ETF managers attempt to minimise tracking error by replicating the benchmark as closely as possible.
An ETF’s historical performance does not necessarily indicate future results, but it is still a factor to consider in choosing between similar ETFs. Similarly, comparing tracking errors can help you decide among funds.
Consider the Total Cost to Invest
Does the ETF minimise expenses? Some checklist questions:
What is the fund’s total expense ratio?
An ETF’s expense ratio often compares favorably to a managed fund’s expense ratio if ETFs are similar in product structure, choose the one with the lower cost, while taking into consideration the transaction costs associated with trading the fund.
Are there guidelines to minimise the fund’s rebalancing costs?
Frequent rebalancing can increase your costs.
What are the trading costs (commissions and transaction costs) associated with buying the ETF shares?
While ETFs’ expense ratios are known to be low, trading ETFs may incur additional costs outside of the ETF (brokerage, etc.) that are important to quantify and compare.
What is the average bid-ask spread?
A narrow bid-ask spread indicates a ready market that may facilitate trading. Narrow spreads are often a sign for more liquidity, whereas wide bid-ask spreads can imply the opposite.
What is the tracking error of the fund?
Returns can deviate from the index, but profound differences may be a red flag of poor management or excessive trading costs.
Can you trade when you want to? Some checklist questions:
What is the ETF’s average daily volume?
High trading activity can mean greater liquidity and more efficient trading.
How does the ETF maintain liquidity?
Due to their unique creation / redemption process whereby authorised participants (APs’) create and provide liquidity when it is needed, ETFs have potential liquidity that may not be evident from assessing trading volume.
Has liquidity been impacted due to market volatility?
Due to their unique in-kind creation / redemption process, an ETF’s liquidity actually reflects the liquidity of the underlying securities. Therefore, if the ETF holds thinly traded securities, APs’ may have trouble sourcing liquidity during times of market stress. Additionally, less liquid ETFs can result in increased trading costs or limited ability to trade in volatile markets.
Does the trading activity cause dramatic price swings?
Large spreads between the bid and ask price often indicate an illiquid ETF, so you’ll want to study the spreads and market movements over time.
Understand the Fund Provided
Does the firm have a solid reputation in the ETF marketplace? Some checklist questions:
How experienced is the ETF provider in developing and managing ETFs?
Large, well-established firms with a long ETF history may have an advantage in this evolving marketplace.
What are the firm’s total assets under management (AUM and their ETF’s AUM?)
Total assets under management indicate stability while high ETF assets further illustrate a commitment to the ETF marketplace. Larger AUM firms typically benefit from greater economies of scale that can benefit the overall costs faced by ETF investors.
Does the firm enjoy good relationships with index providers and the adviser community?
Solid industry relationships indicate that the ETF provider will not only support current funds, but continue to develop new products.
How does the firm manage risk?
A disciplined investment process, broad market expertise and a powerful global investment platform can help manage risk in today’s uncertain market.
Does the firm provide valuable trading support and ongoing education?
In today’s dynamic ETF marketplace, expert trading support and actionable investment strategies can positively impact your bottom line.
Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900, ABN 16 108 671 441) ("SSGA, ASL"). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia · Telephone: 612 9240-7600 · Web: www.ssga.com.
State Street Global Advisors, Australia Services Limited (ASL) (AFSL Number 274900, ABN 16 108 671 441) is the issuer of interests and the Responsible Entity for the ETFs which are Australian registered managed investment schemes quoted on the AQUA market of the ASX or listed on the ASX. This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. You should seek professional advice and consider the product disclosure document, available at www.ssga.com/au, before deciding whether to acquire or continue to hold units in an ETF. This material should not be considered a solicitation to buy or sell a security. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETF's net asset value. ETFs typically invest by sampling an index, holding a range of securities that, in the aggregate, approximates the full index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Investing involves risk including the risk of loss of principal. Diversification does not ensure a profit or guarantee against loss. Holdings and sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. Sector ETF products are also subject to sector risk and non-diversification risk, which generally results in greater price fluctuations than the overall market. SPDR and Standard & Poor's® S&P® indices are trademarks of Standard & Poor's Financial Services LLC and have been licensed for use by State Street Corporation. The Dow Jones Global Select Real Estate Securities Index is a product of S&P Dow Jones Indices LLC and has been licensed for use by State Street Global Advisors, ASL. MSCI indices, the property of MSCI, Inc. ("MSCI"), and ASX®, a registered trademark of ASX Operations Pty Limited, have been licensed for use by State Street Global Advisors, ASL. SPDR products are not sponsored, endorsed, sold or promoted by any of these entities and none of these entities bear any liability with respect to the ETFs or make any representation, warranty or condition regarding the advisability of buying, selling or holding units in the ETFs issued by State Street Global Advisors, ASL. State Street Global Advisors Trust Company (ARBN 619 273 817) is the trustee of, and the issuer of interests in, the SPDR® S&P 500® ETF Trust, an ETF registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940 and principally listed and traded on NYSE Arca, Inc. under the symbol "SPY". State Street Global Advisors, ASL is the AQUA Product Issuer for the CHESS Depositary Interests (or "CDIs") which have been created over units in SPY and are quoted on the AQUA market of the ASX. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors, ASL's express written consent.