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What to consider when selecting an ETF

  • Investment Insights
  • 5 minute read

ETFs have grown in popularity and come down in cost greatly in recent years. Anyone can get a slice of the action – but does cheap equal value? In our view, not all ETFs are created equal and establishing which ones are fit for purpose is a job for an expert.

At the highest level, our Close Tactical Select Passive (TSP) fund range is anchored to our Tactical Asset Allocation (TAA) and seeks to express the views of our Investment Committee. Extensive research follows – if we are seeking exposure to the US, for example, which index do we choose and which provider is best? As a starting point, we use a proprietary due diligence methodology to assess the fundamentals of both the provider and the ETF itself. We recently spent some time at HSBC meeting the CEO, Portfolio Managers (PMs) across both equity and fixed income divisions and risk managers to 'get under the bonnet' of their risk framework – are their systems robust, how is risk controlled and what stops PMs from exercising excessive risk? We seek to understand counterparty risk, capitalisation, legal structure, the stock lending policy, swap replication and fund rebalancing among other questions.

The forensic nature of this work continues at instrument analysis level. We believe the OCF and average bid/ask (b/a) spread are most important when working out what the ‘return cost’ of getting in and out of a position is. If the b/a is 10 basis points more on Fund A than Fund B, then this additional cost means it’s harder to eke out a return or, at the very least, replicate an index/factor from an investment which is meant to be fundamentally cheap. If the trade is expressing a short-term tactical call, the effect of higher trading costs can be even more profound. It’s noteworthy that funds with the highest AUM typically have the lowest OCF (a function of greater clout) and so, all things being equal, ought to offer better value.

Performance and tracking error come next. How closely does a fund’s performance reflect the index it’s following? Tracking Difference is the difference in performance at any time from the fund to the index – the constituents of an index are in constant relative flux, and at any time Stock A within the fund may be over- or underweight versus its actual index weighting. Think of the constituents of the fund as a balance sheet which has to be accurately reconciled and remember that – at least where physical ETFs are concerned – when and how PMs choose to bring over- and underweight positions back to neutral has a trading cost. Concurrently, PMs are also managing the fund’s net cash flows and all moving parts need to be considered. So it is not only a question of how faithfully an index can be replicated, but of managing the costs of doing so as these detract from performance. And this feeds into Tracking Error – the Standard Deviation (SD) of the tracking difference over a defined period and data set. (Typically we favour SD calculated on weekly data taken over one year, as this also helps filter out some of the noise).

In the end, a selection of ETFs tracking the same index can deliver very different outcomes. Take the FTSE100: from July 2017 to July 2018, the FTSE 100 UCITS ETFs on our list returned between 9.13% and 9.62% (almost 0.50% different) while their quoted OCFs varied between 0.07% and 0.20% (0.13%). These differences can compound and hinder performance.

ETFs are popular and they may be cheap – but they haven’t made experts of the average investor. Tracking error, OCF, AUM, replication methodology, b/a spread and liquidity are a handful of the elements investors should consider. Close Brothers Asset Management's expertise and trusted stewardship of clients’ assets in this area are worth the additional cost.

 

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This article is only intended for use by UK investment professionals and should not be distributed to or relied upon by retail clients.  The value of investments will go up and down and clients may get back less money than they invested. Past performance is not a reliable indicator of future returns. The information contained in this document is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This document is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.

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