As the world of exchange-traded funds (ETFs) becomes bigger and more complex, it is becoming more important for clients and their financial advisors to look under the hood and examine the various components of individual products, a conference on ETFs was told yesterday.
“Make sure you know what the ETF owns and that it’s the type of investment you want,” Michael Iachini, managing director of ETF research at San Francisco-based Charles Schwab Investment Advisory, told ETF.com‘s Inside ETFs Conference in Florida Sunday. “As there is more departure from core index-based ETFs, there is more to look at.”
The issue of what is contained in the underlying basket of securities represented by an ETF is coming up more often as providers offer a growing number of ETFs based on a mix of specific securities-selection factors or “smart beta” in addition to ETFs based on broad market indices. The underlying portfolios of smart beta ETFs can change more frequently than index-based ETFs as securities move in and out of the ETF based on their ability to meet the selection criteria.
There are also a growing number of ETFs that offer exposure to less liquid asset classes such as high-yield bonds, emerging markets and narrow industry sectors, and investors need to consider the risks of the exposures they are getting with their ETFs, he said.
Although the management expense is an important component of choosing an ETF, other factors such as the bid/ask spread when ETFs are bought and sold and the tracking differential vs the underlying index also have an impact on costs and returns, Iachini said.
As with trading stocks, you want to see a tight spread on the bid and ask prices with ETFs, he said. The price should be close to the net asset value of the underlying securities in the ETF, or your client’s returns may be negatively impacted.
Different types of ETFs tend to have different spreads depending on the types of securities they represent. For example, broad equity ETFs tend to trade at a narrow spread of 10 basis points (bps)or so between the bid and ask, while commodity-based ETFs typically have spreads in the 30-40 bps range.
“Most ETFs trade close to [net asset value (NAV)], but all ETFs can get out of balance sometimes and you can get caught paying a premium or a discount,” says Matt Hougan, president of ETF.com, a U.S.-based research and information website.
By contrast, mutual funds are always bought and sold at NAV, but they lack intraday trading and prices are set only at the end of the day.
“If I see a bid/ask spread any greater than a quarter of one per cent, I would push that ETF off to the side,” says Iachini.
Iachini avoids new ETFs until they develop an active market and sufficient liquidity.
“We don’t consider investing in a new ETF until it has traded for at least three months,” he said. “We want to see how it trades and we want a nice tight spread.”
Hougan says there can also be big differences in ETF portfolios, even when they invest in similar markets, and this can affect returns. For example, in the year ended Dec. 31, 2014, there was a 57 percentage point difference in the top- and bottom-performing ETFs investing in China. In another example, he said the S&P 500 and Russell 1000 indices both track a broad mix of large U.S. companies, but their portfolios are different and investors should decide what kind of exposure they want.
“That’s why you have to look under the hood,” says Hougan.
Dave Nadig, chief investment officer of ETF.com, said tracking difference between the ETF’s performance and that of the underlying index is also important to investors. Although the relatively low management expense ratio (MER) of ETFs is easy to assess and one of ETFs most popular features, the cost of lagging the relevant index can be more significant, he told the conference, and advisors should examine an ETF’s history of index-tracking to make sure it is keeping up.
“You can calculate the difference yourself, using the index returns over a given period vs the performance of the ETF,” Nadig says. “The difference can be more significant than the management expense ratio. Investors can get hung up on the MER, but there is a lot more going on.”