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As of the end of January, there were more than 3,900 exchange traded products courtesy of dozens of issuers listed on U.S. exchanges so it’s understandable that advisors aren’t fluent in all of these products.
Their time is better spent elsewhere, but that’s not excuse for not performing adequate due diligence on ETFs for possible inclusion in client portfolios. Smart advisors know that process includes more than evaluating based on fees and issuer brand recognition. To be sure, those are valid considerations. It’s hard to justify to clients why an ETF from obscure sponsor is residing in their portfolio. It’s even harder to explain why a high-fee ETF, regardless of issuer, is included in the fray.
Still, advisors need to go beyond branding and fees when it comes to ETF selection. There are myriad reasons why that’s the case not the least of which is the fact that brand recognition is a guarantor of returns and while low expense ratios help on that front, “cheap” doesn’t always mean “good.” In fact, there are some issuers that don’t have Schwab-level brand visibility and lack Vanguard-esque fee and still do quite well by investors.
Point is ETF selection is about more than superficial metrics and the good news for advisors is moving beyond face-value evaluation doesn’t require much added work.
Examination and Evaluation Tips
As noted above, issuer brand isn’t the end all and be all of ETF selection, but let’s be honest. There are reasons the big issuers are, well big, and why others struggle to stay in the game.
“Total assets indicate stability while high ETF assets further illustrate a commitment to the ETF marketplace,” according to State Street Global Advisors (SSGA). “Solid industry relationships indicate potential for the ETF provider to both support current funds and continue to develop new products.”
One of way looking at that quote is that as an advisor, you want to find issuers that have already displayed commitment to their ETF rosters and dedication to growing that part of their business. These days, those attributes aren’t hard to find.
Another point of emphasis for advisors should be index evaluation – a practical tip when considering the vast majority of ETFs are still passive products. Index age and simplicity in construction are points to consider and go a long way toward explaining why the three largest ETFs in the U.S. all track the cap-weighted version of the S&P 500, but there’s more to the story.
“Disparate index weighting methodologies can lead to differences in performance and risk/return characteristics among seemingly similar indexes,” adds SSGA. “The more frequently the index reports holdings, the greater the transparency, and the easier it is to determine how closely the ETF tracks its index.”
Look at Liquidity
A common mistake many retail investors commit is gauge ETF liquidity solely by on-screen volume. They look at two similar ETFs and make their selection based on the one with higher average daily volume thinking they’re getting a better deal from a total cost of ownership perspective. That’s possible, but volume and spreads are more material to short-term traders, not long-term investors.
Moreover, those factors ignore the creation/redemption process that’s unique to ETFs and acts as the source of true liquidity. Translation: ETF liquidity is important, advisors should consider it and those funds with underlying securities with markets that aren’t vibrant can be problematic.
“Due to their unique in-kind creation/redemption process, an ETF’s liquidity actually reflects the liquidity of the underlying securities. Therefore, if the ETF holds thinly traded securities, APs may have trouble sourcing liquidity during times of market stress. Additionally, less liquid ETFs can result in increased trading costs or limited ability to trade in volatile markets,” concludes SSGA.