The advantages of ETFs are clear: they’re cheap, simple, and they enable investors to put their money into a wide range of investment assets. However, there are thousands of ETFs on offer in London alone, so selecting ETFs for your portfolio can be daunting.
And that’s where the Elston Top 50 comes in. It’s an attempt to highlight 50 of the best ETFs listed on the London market.
The man behind the list is Henry Cobbe, the Head of Research at Elston Consulting, and on the latest ETFstream podcast, he explained that the list comprises ‘the fifty most efficient ETFs for 50 key asset exposures.’
What does that mean?
‘Efficiency’ means how well an ETF tracks its underlying index. The most efficient ETFs should closely track their benchmark indices on a consistent basis.
The easiest way to explain ‘asset exposures’ is to give some examples. Here are three: Global Developed Market Equity, UK Small Cap Equity and Global Inflation-Linked Bonds. Each exposure is a part of an asset class. The Top 50 list includes exposures in four asset classes: Equities, Bonds, Alternatives and Cash Equivalents.
Cobbe said he had discovered 130 exposures when preparing the Top 50, but he had decided to steer clear of the more obscure ones and have a list of 50 exposures.
Picking an index
For some exposures there’s an obvious leading index for that exposure – for example, the FTSE 100 is clearly the primary index for UK Large-Cap Equity. But for some exposures it’s not so obvious. Looking at Global Equity, you might go for the MSCI AC World Index or the FTSE All-World Index. Elston selected the MSCI AC World Index because it has more ETFs against it, and that rule is applied across the list.
Once you’ve got the index, the next step is to discover which ETF tracks that index most efficiently.
The efficiency is measured using four measures:
- Tracking difference (difference of annualised performance)
- Tracking error (volatility of excess returns)
- Hurst exponent (long-term persistence of excess returns)
- Kurtosis (width of extreme excess returns)
Using these measures, Elston can pick a top ETF for each exposure and these ETFs enter the Elston Top 50. So for UK Large Cap Equity, the winning ETF is the Lyxor FTSE 100 UCITS ETF (L100).
What about charges?
You might think there are simpler ways to compare ETFs. For instance, an ETF’s charges. If you’re comparing a number of ETFs that track the same index, focusing on charges is a simple way to pick one ETF from the crowd.
Cobbe argues that would be a mistake: ‘You could have a very cheap ETF that doesn’t track the market very efficiently and you could also have a slightly more expensive ETF that tracks the market more efficiently and therefore….all in all, you’re getting a better return.’
All other things being equal, low charges will boost the efficiency of an ETF because it means there will be lower tracking difference. But all other things may not be equal, and other issues can make the ‘cheapest’ ETF less efficient.
It’s also possible that an investor might get lucky and pick an ETF which then proceeds to outperform its benchmark over the following year. In other words, you might make money but the efficiency of the ETF would be poor. (Because it hasn’t tracked the ETF closely.) The problem with this kind of inefficiency is that the ETF might then underperform its benchmark the year after. What you really want is an ETF that consistently tracks its benchmark very closely year after year.
The obvious flaw with Elston’s system is that it doesn’t evaluate the different indices that might be on offer for an exposure. Imagine we have two available indices for an exposure: Index A and Index B. Index A has three ETFs tracking it while Index B only has one. As things stand, the ETF tracking Index B has no chance of entering the Elston Top 50. Elston will focus on the three ETFs tracking Index A. Trouble is, Index B might be the ‘better’ index – perhaps because it has more constituents or for some other reason.
Still, even with this downside, the Elston Top 50 should be a useful tool helping investors narrow down the pool of ETFs that they might consider using.
Which ETFs are in the top 50?
You can read about some of the winners in these articles:
You can also preview the Elston Top Fifty here (free extract). But if you want to see all 50 winners you will have to buy the report. Elston Consulting isn’t taking any payments from ETF providers and that means the firm has to generate some revenue from users.
Contact Elston to buy the full list of all ETFs that were evaluated for an award.
You can also find out more by listening to the ETFstream podcast where Ed Bowsher interviews Henry Cobbe.