FTAdviser.com

Advertising

The exchange-traded fund (ETF) universe is developing exponentially, and is expected to reach $2trn (£640bn) in assets globally by 2011. As the range and depth of the product grows, it has become increasingly important for investors to ‘look under the hood’ of any ETF before they buy. They should not just consider costs, but also other structural differences between products that, at first glance, appear similar.

While cost is certainly an important consideration, there are other significant factors to be examined. For example, how accurately does the ETF capture its sector or asset class? Are there other implicit costs besides the expense ratio? How liquid is the security? Choosing the wrong ETF can negate the advantages of the product - the ability to access an asset class cost-effectively and transparently.

There are five criteria to take into account when evaluating an ETF:

- Know what the ETF owns: what securities does the chosen ETF index contain and how will this affect portfolio performance?

- Consider total costs: the total expense ratio is only one cost factor to consider when owning or managing ETF portfolios.

- Look inside liquidity: the liquidity of an ETF can be a significant contributor to total costs.

- Assess the structure: there are different types of ETFs, which carry their own unique exposure, risk and tax implications.

- Evaluate the provider: does the ETF provider have extensive experience managing index investments?

Indices indicate the health of a market on a daily basis and are the benchmark for an ETF's performance. Given the key role that indices play, it is important to remember that every index is unique. Two indices that cover similar areas of the market – even with similar-sounding names – can differ greatly from each other and will possess unique risk/return profiles. It is therefore essential to understand the characteristics of an ETF's underlying index and whether this index is the most appropriate for a client’s investment objectives.

Each index provider creates its own set of requirements to define an index universe. For equity ETFs, key differences in index construction methodologies can include the number of constituents, market capitalisation, style and sector composition. For fixed income ETFs, providers build indices around criteria such as credit quality and maturity. Understanding differences such as these can help ensure that portfolios contain the correct ETF for a client’s investment requirements.

Costs are also a consideration when selecting an ETF. Understandably, the TER - the total paid to cover the costs of fund management, trustees, licensing and operational costs - is an integral part of the decision-making process. However, an ETF's TER forms just one element of its total cost. Investors should also consider the effect of additional implicit costs such as trading expenses and portfolio rebalancing.

The market price of an ETF is typically reflected in the bid/ask spread. ETF spreads tend to be lower for larger funds (higher assets under management) and funds with higher daily trading volumes. In addition, the more liquid the underlying securities of the index, the lower the spreads for the corresponding ETF can be. Since ETFs are bought and sold like ordinary stocks, brokerage commissions will also apply. Both these costs (bid/ask spreads and broker commissions) become more important as the investor’s investment horizon shortens.

Index providers, such as FTSE, S&P, MSCI and Dow Jones, rebalance their indices to include securities that reflect their selection criteria most closely. The resulting inflow and outflow of securities will generate costs for ETFs. Rebalancing costs will vary depending on the ETF structure.

A positive feature of ETFs is the opportunity to earn additional revenue that can help offset the various costs of ownership. Securities lending is perhaps the most notable example of this. Lending can take place at two levels: within the fund and lending of the fund units. At the first level, the fund manager can lend out the basket of stocks that constitute the holding of the fund to generate extra income. This income is shared with the fund, thus offsetting the TER. The second level lies with the final investor, who can lend out the ETF units owned to generate additional returns (this lending process works in exactly the same way as with any other stock). This can be done via inhouse lending desks.

Additional sources of revenue can include dividend enhancement and the intelligent management of index events. The combination of all these revenue-gaining techniques can sometimes be sufficient to offset completely the total expense ratio incurred while holding an ETF position.

The liquidity of an ETF is yet another key consideration. The more liquid an ETF, the easier and more cost-effective it will be to trade. Conversely, poor liquidity can translate into difficulties in entering and exiting positions, alongside higher trading costs.

ETFs offer two levels of liquidity – traditional liquidity on exchange or OTC (both referred to as the ETF secondary market), and the liquidity provided on the primary market by the creation/redemption mechanism. This mechanism allows authorised participants to exchange baskets of securities or cash for ETF shares (and back again) without meaningfully affecting the underlying market. This ability to create or redeem shares at any time maintains an ETF price in line with its underlying net asset value, and ensures liquidity is derived largely by the underlying securities within the ETF.

While most investors trade on the secondary market, both secondary and primary markets need to work well to ensure an efficient market with tight spreads, translating into lower costs. There are two questions to ask when deciding the best way to trade an ETF:

First, what is the spread? It is the difference between the bid and the ask; it is the cost to the investor, imposed by the market maker, of buying or selling the ETF. The spread should be as tight as possible around the mid price to make the purchase/sale competitive.

Second, what is the depth of the market? This refers to the size of order an investor can execute. If the order book indicates an investor can buy or sell 10,000 units, then up to that many units can be bought without a need to consider any other method of execution. Larger transactions (typically the higher of 20 per cent average daily volume or five times the average order book) may require one to trade OTC directly with a market maker.

There are two major constructions of ETF: in-specie-based ETFs (or cash-based) and swap-based ETFs. In addition, there are other exchange-traded products that are often confused with ETFs, the most notable being exchange-traded commodities (ETCs), also known as exchange-traded notes (ETNs).

An in-specie-based ETF generally buys all the securities in the underlying index and holds them as fund assets (a process known as full replication). In some instances, however, an in-specie fund will only hold a subset of the underlying index, or even a portfolio designed to better emulate the overall performance of the underlying index, a process known as optimisation.

A swap-based ETF uses total return index swaps to replicate an index performance. Swap-based ETFs can, in some instances, reduce tracking error and provide a more tax-efficient investment. However, the fund does have a managed exposure to the swap counterparty, which involves consideration of counterparty risk.

ETNs are most commonly issued to give investors exposure to the commodities sector, hence they are also known as ETCs. ETNs can track a specific commodity or a general commodity index. Importantly, they are not collective investment schemes and are not regulated as funds. ETNs are debt securities: investors in ETNs will generally take some credit risk to the issuer of the security.

Experience matters. Size, scale, expertise and commitment can vary significantly between ETF providers, and these differences can affect performance across several areas. Investors should evaluate a provider’s:

• scale of operations to minimise costs and manage market impact;

• track record in index portfolio management, minimising tracking error and trading costs;

• dedication to providing servicing support and resources to investors, intermediaries and market participants;

• knowledge of index construction and methodology; and

• commitment to product development.

ETF providers should have extensive experience of managing index investments, proven portfolio management skills and dedicated research teams. However, just as important should be the ETF provider’s commitment to educating primary and secondary market investors on new developments within the sector.

Ultimately, evaluating ETFs often involves trade-offs. As an example, a client may prefer to invest in an ETF that is very liquid, with a low trading spread, in order to lower trading costs, regardless of a higher tracking error.

All clients have their own investment requirements and their own tolerance of risk versus return. The question investors should ask is not: ‘What is the best ETF?’ but ‘What is the right ETF for this client’s portfolio?’

Nick Shellard is head of UK sales for iShares