An ETF Due Diligence Checklist

Even as new indexes are constructed, the index provider’s tenure in the marketplace can indicate a measure of stability.

Understanding an index’s focus allows you to pinpoint the exact exposure you need for a client’s portfolio.

Disparate index weighting methodologies can lead to differences in performance and risk/return characteristics among seemingly similar indexes.

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.

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.

Large, well-established firms with a long ETF history may have an advantage in this evolving marketplace. 

Total assets indicate stability while high ETF assets further illustrate a commitment to the ETF marketplace. 

Solid industry relationships indicate that the ETF provider will not only support current funds, but continue to develop new products. 

A disciplined investment process, broad market expertize and a powerful global investment platform can help manage risk in today’s uncertain market.

In today’s dynamic ETF marketplace, expert trading support and actionable investment strategies can positively impact your bottom line. 

A greater number of holdings means increased diversification benefits for the portfolio. 

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.

Solid industry relationships indicate that the ETF provider will not only support current funds, but continue to develop new products. 

Having a large portion of the fund invested in a handful of holdings can lead to concentration risk.

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. 

Significant portfolio overlap can leave your clients over-exposed to various sectors, companies or issuers.

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.

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 38% of today’s ETFs.² Greater assets under management can also enhance a fund’s liquidity.  

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.

Income from securities lending could reduce fund expenses, and understanding the collateralization process can help you assess potential risk. 

With an ETF that seeks to track the performance of an index, ideally, the fund should tightly track its index.

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. 

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. 

Frequent rebalancing can increase your costs.

While ETFs’ expense ratios are known to be low, trading ETFs may incur additional costs that are important to quantify and compare.

A narrow bid-ask spread indicates a ready market that may facilitate trading.

Returns can deviate some from the index, but profound differences may be a red flag of poor management or excessive trading costs. 

High trading activity can mean greater liquidity and more efficient trading.

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. 

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. 

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.