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—it needn’t be difficult. Selecting an ETF from the sizeable universe of more than 6,500 funds can be time consuming and overwhelming. Knowing what you own is an important investment principle regardless of whether you are buying a security, mutual 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.
Does the index and/or fund objectives align with your portfolio?
Some checklist questions:
How long has the index existed?
New indexes 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.
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, optimization-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 capitization weighting scheme, or is it equal weighted?
A market capitalization 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 recognized 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 collateralization process, and how is it managed?
Income from securities lending could reduce fund expenses. Understanding the collateralization 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.
Does the ETF minimize expenses? Some checklist questions:
What is the fund’s total expense ratio?
An ETF’s expense ratio often compares favorably to a mutual 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 minimize 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 spread 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 authorized 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.
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 advisor 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.
If exchange traded funds interest you, speak to your advisor or broker to determine if you could benefit from incorporating ETFs into your investment plans. Your advisor can help you analyze your current investments, risk tolerance, tax situation and time horizon, and then recommend strategies to help you achieve your goals.