How do you choose an exchange-traded fund (ETF)? The answer should go well beyond finding the lowest-cost options. In this article, we outline a few key considerations for anyone performing ETF research and due diligence.
ETF costs are only the start of the ETF story
In the early days of ETF investing, what mattered most to investors and their advisors was an ETF’s market cap target and its cost.¹ For many today, these continue to be the components that are most scrutinized. As market-cap-weighted index-tracking ETFs have grown in number and size, their costs have continued to decline.
Unfortunately, if also unsurprisingly, the ETF expense ratio arms race has tended to blind investors to other important developments in the ETF market, particularly the growth of certain structural differences.
Before you buy or recommend an ETF, we think it’s critical to build up your understanding of what’s under its hood. With some well-placed due diligence, you can look beyond the least expensive ETFs and find options that are much better suited to meeting your needs.
Key considerations for ETF research
|Market exposure||What index does the ETF track?||How do major indexes in the category differ?|
|Factor exposure||Is the ETF factor based? Which factor or factors does it pursue?||If multiple factors are pursued, how are they combined?|
|Reconstitution/rebalance||What is the rebalance schedule and how might that impact costs?||Do the rules governing the ETF attempt to reduce the drag of trading costs?|
|Portfolio fit||How does the ETF fit within your larger portfolio?||If market cap is a target, do holdings overlap substantially or minimally with adjacent size categories?|
Market exposure: indexes matter
Even plain-vanilla market cap index-tracking vehicles can differ from each other in important ways. Two common indexes that track the emerging markets offer a good example. While the Morgan Stanley Capital International (MSCI) Emerging Markets Index includes South Korea, the FTSE Emerging Index maintained by FTSE Russell does not. For an investor in an emerging markets ETF, this can be a big deal.
If you’re considering an ETF that tracks the FTSE Emerging Index, it won’t include exposure to some of the today’s best-known, biggest, and most profitable global brands, such as Samsung Electronics, LG Electronics, and Hyundai Motor. Perhaps that’s something you’re okay with—as well as the more concentrated exposures to other emerging markets that a South Korean omission implies—but then again, perhaps not. The important thing is to be aware of this kind of difference.
Factor exposure: in pursuit of market premiums
As the ETF market has evolved, it has taken on additional layers of complexity in the form of factor proliferation—where factors, understood as persistent characteristics like quality and relative price, become the guiding lights for custom ETF index and portfolio construction.
This can make a big difference for investors who, for example, want to compare a market-cap-weighted mid-cap ETF that seeks to capture the overall mid-cap market’s return and a factor-based mid-cap ETF, which might seek to provide better risk-adjusted returns than the same market segment. This difference in objective goes a long way toward explaining the cost difference between market-cap-weighted and non-market-cap-weighted ETFs.
Some common factors and their objectives
|Value||Seeks to capture the excess return that academic research suggests persists among stocks with low relative price, such as price-to-book data|
|Small cap||Seeks to capture the excess return that smaller market cap companies have exhibited relative to larger-cap companies over time|
|Low volatility||Seeks to capture the excess return associated with lower “beta” or lower-volatility stocks based on relative price fluctuations|
|Quality||Seeks to capture the excess return associated with higher quality, as evidenced by companies’ income statements|
|Momentum||Seeks to capture the excess return associated with stocks whose trailing returns have shown a propensity to outperform|
Knowing your factor-based goals is critical. What are the factors you want exposure to and why? Do you want a product that focuses on a single factor or a more diverse, multifactor approach? Which factor index best reflects your goal? While opening a factor-based discussion in your due diligence can feel daunting, we offer research to help you navigate some of the key decision points.
Reconstitution: your index-tracking ETF may carry hidden costs
Because the market is always changing, indexes have to keep pace. Some stocks experience corporate actions—like a buyout or merger—so they disappear from the index; other times, new securities for companies that have just gone public may get added to the index. To take these changes into account, indexes update their constituents and the weights of individual holdings. When this happens, it can trigger trading activity in the entire portfolio. This can have big implications for an ETF’s trading costs, which aren’t reflected in the ETF’s expense ratio.
In addition, index-based ETFs have a rebalance schedule that could be as frequent as monthly or as infrequent as annually. As a result of an ETF’s mandate to match the market, it may need to purchase and sell numerous securities on the date of the underlying index rebalance. Because demand for different stocks can be massively influenced by the amount of assets tied to a given index and the number of shares being added or dropped from each one, the ETF you may be considering could be forced into a challenging market situation during rebalance periods.
It’s important to know how your ETF handles index reconstitutions and rebalances—whether it passively tracks index constituent and weight changes, or whether it employs a more creative approach to reconstitution to get around price distortions resulting from process-driven index changes.
Portfolio fit: consider the big picture
No matter how you intend to use ETFs, it can be helpful to consider the degree of portfolio overlap that one ETF may have with other segments of your portfolio.
For example, if you’re looking to ETFs to cover the market cap spectrum of small-, mid-, and large-cap stocks, you may not need to buy three ETFs, but only two. The reason for that is some large-cap ETFs already contain significant mid-cap exposures.
Alternatively, if you’re thinking of using factor-based ETFs to build satellite exposures to a core portfolio in order to enhance overall portfolio returns, it’s important to know how these ETFs may overlap with any satellite sector exposures in the same portfolio.
From another perspective, it can be useful to think of index-tracking and factor-based ETFs alongside actively managed mutual funds in your portfolio. Some categories—such as mid-cap stocks—may be best approached through passive and multifactor smart beta strategies, as research from John Hancock Investment Management has shown.
Knowing your goals is half the battle
Many investors have turned to ETFs as an inexpensive option for buying the market’s return. But cheap market exposure is no longer the only—or necessarily the most compelling—reason to buy an ETF.
Advisors today must spend more time familiarizing themselves with the ETFs they’re considering—and they should get more comfortable talking about how different types of ETFs work. Knowing when you’ve found the right ETF can mean knowing a lot more about how it’s built to do what it says and what you want to accomplish with it.
1 For the most diligent ETF researchers, knowing about an ETF’s average daily trading volume was also frequently a top concern. However, equating daily trading volume with an ETF’s liquidity was and continues to be a common mistake.