The need to apply best practice when selecting ETFs is more important than ever, as new products with enticing narratives increasingly find a home in the portfolios of European investors.
In the build-up to ETF Stream’s ETF Ecosystem Unwrapped event on 26 May, fund buyers offered ETF Stream some of their top tips for cutting through the noise – to help investors fulfil their objectives by picking apart the overwhelming range of products on offer.
A good place to start is on costs, which are the first port of call for prudent investors looking to avoid a dent in their long-term returns.
Simon McConnell, portfolio manager at Netwealth, said a holistic view of costs is required, whereby investors need to look beyond annual fees – total expense ratios (TERs) or ongoing charges figures (OCFs) – and also consider the impact of bid-offer spreads and charges associated with data collection for schemes such as the European MiFID Template.
Dan Kemp, chief investment officer for EMEA at Morningstar, pointed out index fees are one of the main costs for ETF providers and are passed onto investors.
This fact will not be lost on sustainable investors, with environmental, social and governance (ESG) indices often more expensive than their parent benchmarks. Likewise, thematic ETFs often charge ten times the basic fee – not including spreads – of core index trackers.
Kemp added another cost of indexing can be branding, with top index providers charging a premium because of their established reputation and dominant stake.
“As new index providers enter the market it is often possible to access exposures that are very similar to those of the most widely recognised indices at a lower cost,” Kemp added.
Aside from cost, investors also need to look under the bonnet of an ETF to discern whether the contents fully match the label on the tin.
For this, prospective buyers need to take a closer look at a product’s underlying benchmark, and see whether they will get the desired exposure to factors such as ESG compliance or purity of exposure to a particular theme.
McConnell said: “For a market-cap weighted benchmark this is relatively straightforward, but with the proliferation of ESG and smart-beta indices, it is vitally important to understand exactly what is going on with the stock selection, index weighting.”
After this, it is also useful to find out how successfully an ETF tracks the index it claims to replicate, by looking at tracking error and tracking difference.
Should an investor be satisfied their exposure aligns with their specific preferences, they then need to consider whether these are compatible with the necessities of trading, such as the need to ensure liquidity.
Speaking on ETF selection, John Leiper, chief investment officer at Tavistock Wealth, said: “While we do not have a specific target, the ETF liquidity profile should be commensurate with the size of the investment and relative to our expectation of potential risk and return.”
This risk-return dilemma and the theme purity-diversification-liquidity trade-off were illustrated in the high-profile rebalancing of the iShares Global Clean Energy UCITS ETF (INRG) underlying index by S&P Dow Jones Indices (SPDJI), where fears of over-concentration in a handful of illiquid small-cap stocks saw SPDJI’s clean energy benchmark more than double in size. This reduced INRG’s purity but greatly increased its diversity and liquidity – improving its risk-return profile.
Specific red herrings
Fund buyers also think it is important to set the record straight on some of the most high-profile conversations being had within the world of ETFs.
One of these issues is on the subject of physical versus synthetic replication. Rightly or wrongly, the latter has been out of favour over the past decade, with critics often pointing towards counterparty risk – which can be mitigated against by collateralisation – and valid points about diminished transparency.
However, from a returns point of view, it is hard to argue against the appeal of a well-regulated synthetic replication.
Kemp said: “While synthetic ETFs gained a poor reputation in the first decade of this century, there are tax advantages to using some synthetic ETFs that can meaningfully add to returns.”
Additionally, swaps mean synthetic strategies can track the performance of a fully-replicated or optimised index and achieve alpha versus physically-backed ETFs when the prices of underlying securities change.
Another important conversation going on in the ETF community is what the ESG label means and whether it can be relied upon.
“Many of these products have similar labels but very different exposures,” Kemp continued. “It is important to look beyond the ESG brand and understand the specific exclusions and methodology of the product you are buying.”
Not only has the product class only recently gained a dominant portion of European ETF flows – including 52% of new assets during Q1 – but is moving at such as pace that new launches occur faster than analysts can properly scrutinise what is already on offer.
ESG means different things in different geographies, with Europe prioritising the environmental element while US investors focus on the social aspect. While tedious, the lack of a fixed standard or understanding of ESG means that for an investor to be happy with the ESG credentials of products within a particular exposure, they will have to go through each ETF to find the ones (if any) that fulfil their needs.