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Sometimes old lessons hold their value over time and occasionally bear repeating. That’s the case with the following about exchange traded funds and the advice really rings true at a time when ETF adoption among advisors and professional and retail investors continues soaring.
The pearl of wisdom is of know what the ETF holds or “look under the hood.” It’d be reasonable to assume that after three decades of exponential growth for ETFs, this is now perfunctory advice. For many advisors, it probably is. Still, the ETF landscape is littered with examples of fund names that don’t always adequately or accurately indicate what makes the ETF tick.
For example, it’s possible to find fixed income ETFs that appear to be investment-grade product that also hold significant amounts of junk debt. Likewise, there are some small-cap ETFs out there that devote large percentages of their rosters to stocks that are deep into mid-cap territory.
Those are just a couple of examples, but the point is a couple of minutes of homework can prevent headaches while ensuring the exposures that end up in client portfolios are what the advisor intended.
Benefits of ETF Examination
In any environment, there are tangible benefits derived from ETF examination, but that value increases when equity market concentration increases as has been the case of late. Concentration risk is also applicable to geography and sectors.
“An ETF heavily weighted in a particular sector may be more vulnerable to sector-specific risks. Knowing the constituents allows one to assess this concentration,” notes David Graichen, WisdomTree head of capital markets. “For international ETFs, knowing the country allocation helps in understanding the geopolitical and economic risks associated with different regions.”
Then there’s just garden variety concentration that comes by way of a small number of stocks commanding outsized percentages of an ETF’s roster. That’s fine and dandy when those stocks are climbing, but the double-edged sword avails itself during pullbacks, such as the one seen in recent weeks in the U.S.
Additionally, by knowing what an ETF holds – information that’s readily accessible to all investors and updated daily (in most cases) – advisors can ensure strategies lineup with client goals while better understanding what’s helping and hindering an ETF’s performance.
“If an investor is seeking income, an ETF with high dividend-paying stocks would be more suitable. Conversely, a growth-oriented investor might prefer an ETF with a focus on technology stocks,” adds Graichem. “By knowing the constituents, the investor can better understand what drives the ETF’s performance and how it aligns with the investment thesis.”
Practical Steps to Take
As advisors know, the vast majority of ETFs, regardless of asset class, update holdings on a daily basis. Even active ETFs do that. Most active mutual funds don’t do that.
Fortunately, ETF issuers make it easy to access to daily holdings and their websites usually feature regularly updated factsheets and prospectuses. For advisors and investors of all stripes, the process of examining ETF components and investment objectives is streamlined.
“Understanding the constituents of an ETF is a fundamental aspect of informed investing. It enables investors to assess risks, align investments with goals, evaluate diversification, analyze costs and respond proactively to market changes. By taking the time to delve into the details of ETF holdings, investors can make more strategic decisions and optimize their investment outcomes,” concludes Graichen.