Financial advisors should establish a process for analyzing the differences between ETFs and evaluating the potential benefits and risks of each ETF.
An advisor’s objective should be to match the philosophy and structure of a given ETF with client needs. It is important to look at the structure of the ETF, review its underlying index and understand the philosophy of the investment manager. When creating a customized due diligence process, take care to avoid common misconceptions by considering the following:
Exchange traded funds (ETFs) are an integral part of many portfolios, valued by financial advisors and investors alike for their liquidity, transparency and tax efficiency. In recent years, their popularity has soared, fueled by financial advisors who were transforming their businesses to meet investors’ changing needs. As clients asked for assistance with complex wealth management challenges, financial advisors sought potent, flexible investment strategies that would help them solve clients’ problems.
According to the Investment Company Institute, at the end of 2014 there were 1,411 exchange traded funds domiciled in the United States, holding nearly $2 trillion in net assets. That’s up from $228 billion just 10 years ago.* Along with their explosive growth, however, ETFs evolved in complexity, structure and usage. Unfortunately for many advisors, their due diligence process vis-a-vis ETFs did not. Too often, they employed the same tools used to evaluate mutual fund and separate account strategies, meaning potentially that they may have been asking the wrong questions.
We believe that financial advisors should establish a customized due diligence process – one that is structured and deliberate in nature.
This process should recognize the differences between ETFs and evaluate the potential benefits and risks of each ETF. An advisor’s objective should be to match the philosophy and structure of a given ETF with client needs.
Four vital questions are at the heart of this process:
To answer these questions, advisors must look at the structure of the ETF, understand its underlying index and understand the investment manager.
STEP ONE: EXAMINE THE STRUCTURE
Advisors should examine the structure of an individual ETF, such as its investment program, tax consequences, custodial policies and other nuances that could impact its effectiveness.
STEP TWO: UNDERSTAND THE UNDERLYING INDEX
When it comes to choosing an index, advisors should start by asking what it would take to “invest with purpose.”
Advisors should make sure their understanding is clear.
The index must be measurable, appropriate and reflective of current investment options. For equities, determine if it has the desired capitalization weighting, return variance, style, country, sector or manager risk. For fixed income, establish whether the strategy delivers the desired asset class exposure, risk and yield. Advisors should also evaluate the potential challenges and the benefits of beta, alternative-weighted or actively managed indexes.
STEP THREE: UNDERSTAND THE INVESTMENT MANAGER
Before selecting an ETF, an advisor should get to know the investment manager – the firm’s professionals, process, philosophy and performance. Firm philosophies on product development, experience and expertise can vary greatly. In reviewing the prospectus, especially for an active strategy, examine the manager’s investment process.
Additionally, is the ETF created in-kind or with cash? This could have a financial impact on the client’s portfolio.
More broadly speaking, financial advisors should get to know the investment manager by examining the following.
BE SKEPTICAL
In creating a customized due diligence process, advisors must take care to avoid some of the most common misconceptions. Following are three key considerations.
Underlying Investments are More Important than Size
The investments held within an ETF will determine that ETF’s pricing and liquidity. Contrary to popular belief, the size of an ETF has little or no relevance to how it will trade. In reality, an ETF trades based on supply and demand in the market for the underlying investments. For example, an investor could have difficulty selling a steel ETF because the price of steel is falling, not because of the size or viability of the steel ETF itself.
A Focus on Track Record Length May Obscure Critical Details
We don’t think advisors need to see a long track record for every type of ETF. In some cases, they should give more weight to the manager’s investment thesis. With newer strategies – for instance, tilted or alternatively weighted indexes – advisors should decide if they believe in the manager’s investment thesis. Does the manager have a distinct, logical investment approach that can generate the desired outcome? Analytics can be useful in making this determination.
Furthermore, different underlying indexes require different levels of “proof.” A rules-based beta product, such as an S&P 500 Index ETF, fully replicates the index, and investors get what the market gives them. On the other hand, when advisors are considering an ETF benchmarked to the Estonian bond market, they may need to see a substantial track record. Unknown factors could have an impact on such an ETF and as a result, the strategy is likely to require a high level of skill to manage.
Reconsider the Math of ETF Ownership Cost Many financial advisors use the same industry-standard equation for ETFs that is used to determine the cost of a pure beta mutual fund:
Expense Ratio
+ Trading Spread
+ Tracking Error
= Total Cost of Ownership
This equation falls short, however. In reality, there are many different cost considerations when investing in an ETF.
Explicit Costs.
These are the most commonly cited costs in comparative articles or reviews. They include expense ratio, commission and bid/ask spread, all of which are readily identifiable and easy to discuss and understand.
Implicit Costs.
Unlike explicit costs that can be researched across many data sources, implicit costs can be harder to quantify. While they may require more effort to unearth, implicit costs are just as important as their explicit counterparts. Implicit costs include capital gains, turnover within the fund, the funds tracking success against its index (or a standard market benchmark) and distribution or platform fees.
It is important to understand that these costs are not independent of one another; sometimes lowering an explicit cost can increase implicit costs or even reduce the effectiveness of the investment strategy.
Opportunity Costs.
As the ETF product landscape continues to evolve, interest in alternative index weighting methodologies has grown rapidly, particularly in the last several years. Use of these so-called “nontraditionally weighted” indices offers another perspective on costs: the opportunity cost — and the choice of one product over another dictates opportunity cost.
For an in-depth discussion of these three basic categories of ETF purchasing costs, we urge you to review our paper, “The Total Cost of ETF Ownership, An Important — but Complex — Calculation.”
ONCE PROCESS ESTABLISHED, REVIEW ETFS REGULARLY
In our view, many of the metrics used by financial advisors to evaluate ETFs are obsolete. Rather than assessing ETFs the same way mutual funds are evaluated, advisors should create and implement a customized due diligence process that allows them to match products with what is most appropriate for their clients’ needs and objectives. To do so, they should seek to understand a fund’s construction, methodology and investment philosophy to determine whether it aligns with what they are trying to accomplish. And they should fully understand how to more accurately evaluate the total cost of owning an ETF. We recommend establishing a regular review process to verify that the ETFs in your clients’ portfolios are continuing to meet their needs and have the stability to weather change and uncertainty.