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A ETF Due Diligence Checklist
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 more onerous. Selecting an ETF from the sizeable universe of more than 2,350 funds, in the US alone, can be time consuming and overwhelming.1 However, knowing what you own is an important investment principle regardless of whether you are buying a security, mutual fund or ETF. Using this worksheet to create a thorough framework for your analysis can help ensure the ETFs you choose best meet your clients’ needs.
Evaluate the Index/Fund
Does the index and/or fund objectives align with a client’s portfolio?
Questions to ask, and why is this important
How long has the index existed?
Even as new indexes are constructed, the index provider’s tenure in the marketplace can indicate a measure of stability.
Is the index concentrated in particular sectors, companies or countries?
Understanding an index’s focus allows you to pinpoint the exact exposure you need for a client’s portfolio.
What is the index weighting methodology (market-capitalization, price-weighted, fundamentally weighted or equal-weighted)?
Disparate index weighting methodologies can lead to differences in performance and risk/return characteristics among seemingly similar indexes.
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?
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 Fund Provider
Does the firm have a solid reputation in the ETF marketplace?
Questions to ask, and why is this important
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 total ETF AUM?
Total assets indicate stability while high ETF assets further illustrate a commitment to the ETF marketplace.
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 expertize 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.
Examine the ETF’s Product Structure
Does the fund’s structure help mitigate portfolio risks and promote liquidity?
Questions to ask, and why is this important
How many stocks or bonds are in the index and what are the fund’s diversification guidelines?
A greater number of holdings means increased diversification benefits for the portfolio.
What is the investment approach? Does the ETF hold everything in 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.
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.
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’s holdings make sense in terms of the objectives of the fund?
Unlike many of the straightforwardly named ETFs, others belie their name. Therefore it’s necessary to look beyond the fund’s name or 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’s holdings overlap significantly with existing strategies in the client’s portfolio?
Significant portfolio overlap can leave your clients over-exposed to various sectors, companies or issuers.
Does the ETF follow a traditional market capitalization 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 $50 million, a level not matched by 34% of today’s ETFs.2 Greater assets under management can also enhance a fund’s liquidity.
What is the regulatory designation of the ETF (unit investment trust, open-end fund, grantor trust, 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 manage risk and promote liquidity in portfolios.
If the ETF lends securities, what is the collateralization process and how is risk managed?
Income from securities lending could reduce fund expenses, and understanding the collateralization process can help you assess potential risk.
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.
What’s the difference over time between the fund’s return and the index’s return?
An ETF’s historical performance does not necessarily indicate future results, but 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
Does the ETF minimize expenses?
Questions to ask, and why is this important
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 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.
What is the tracking error of the fund?
Returns can deviate some from the index, but profound differences may be a red flag of poor management or excessive trading costs.
Gauge Liquidity
Can you trade when you want to?
Questions to ask, and why is this important
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 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.
1 Bloomberg Finance, L.P as of 03/05/2021
2 Bloomberg Finance, L.P as of 03/05/2021