Five tips for evaluating ETFs

By the end of 2012, the total assets under management of the global Exchange Traded Fund industry is expected to exceed $2 trillion by some estimates, and with nearly 2,500 ETFs now available globally to institutional investors, there is an ETF for almost every conceivable asset class.

While depth of selection of ETFs has certainly enhanced the choice for investors, it has also made it much more difficult to navigate and find the “right” ETF. There are a number of different ETFs that offer Canadian investors exposure to the same asset classes, understanding crucial differences between the features of these ETFs can help investors make a much more informed investment choice.

Here are five tips that can help you in finding the right ETF for your client’s investment strategy.

1. Keep costs low

With management fees in Canada as low as 0.07%, the low-cost nature of ETFs has been a driving force behind their growth. Indeed, most passively-managed index tracking ETFs are a mere fraction of the cost of mutual funds with similar investment mandates. Typically what investors save in fees results in outperformance over the traditional mutual fund, since the vast majority of equity funds underperform their benchmark over multi-year periods.

The concept of switching from a mutual fund to an ETF is very much akin to what has driven generic drug usage—it’s cheaper and does the same thing.

If an investor is buying a passively-managed ETF of a widely-followed index benchmark, you’ll want to make sure the cost of that ETF is significantly lower than actively managed mandates benchmarked to the same index. That cost differential can often be what determines the difference in performance between the index and actively managed strategies that are benchmarked to that index and fail to beat it.

2. Cost isn’t everything

Some ETFs are more expensive for a reason. Usually it’s because they use investment strategies that require a little more oversight by the ETF manager and therefore necessitate a higher management fee.

Most equity indices use a market-capitalization weighting methodology. There are some ETFs that use enhanced index-strategies, which use alternative methodologies to select the securities in the index based on factors that differ from market capitalization.

Generally speaking, the index will have the same stocks as the cap-weighted indexes, but assign different portfolio or index weights than the traditional index. Depending on the equity sector the ETF invests in, using an enhanced index can significantly reduce sector risk or single stock risk in the portfolio, and most of these indices historically have had better back-tested performance than a regular cap-weighted index.

Don’t rule out equal weight or fundamentally weighted versions of an ETF, despite a slightly higher cost, they may provide better risk adjusted returns than a regular cap-weighted index.

3. Does the ETF hold securities?

There are basically two ways to structure an ETF. The ETF can physically hold the securities or commodities it’s tracking or it can use derivatives, such as futures contracts or swaps, where it enters into an agreement with a counterparty to receive the return of an index benchmark or commodity price.

With equity index tracking ETFs, a swap structure can drastically reduce the tracking error of the ETF—the difference between the ETF’s performance and the performance of the index it tracks—since the counterparty is obligated to provide the exact returns of the index. An equity index tracking ETF that physically buys and sells the underlying securities of the index will encounter trading execution problems, which can significantly add to the ETF’s tracking error.

There is no credit risk associated with an equity-index tracking ETF that holds the securities, investors know the net-asset value of their units will be very close in value to the net asset value or market value of the underlying securities which can be liquidated.

With a swap-based ETF, the counterparty is always a well respected Canadian financial institution. All of the “Big 6” Canadian Banks offer counterparty services for swaps.

Futures versus physically-backed commodity ETFs can result in some differences in return. Futures-backed ETFs will periodically need to roll-over the futures contracts they track, when there is a premium to roll into the next contract, an environment known as contango, it can diminish the return of the ETF. Conversely, during a period known as backwardation, there may be no cost, or the investor may in fact be paid to roll into the next contract.

Physically-backed commodity ETFs avoid the impact of contango and backwardation, but they are required to pay a fixed storage cost to hold the underlying commodities. Generally speaking the return performance of physically backed commodity ETF during a period of contango is not that different from the futures-backed ETFs, since arbitrage traders will diminish any inefficiencies that exist between the two structures. The primary difference is an investor in a physically-backed ETF knows they have a specific claim on the physical commodity, but there is fixed-cost for that piece mind. In an environment of low contango or backwardation, the futures-backed ETF will not be subject to that fixed storage cost and may come out ahead in performance.

It’s crucial to remember that in either case, the ETF will not deliver the spot-performance of the underlying commodity.

4. Keep tracking error low

Tracking error is the silent killer of ETF performance. Index-tracking ETFs can deliver very different returns from the index. It is important that you look at the performance of the ETF and similar competitors against the benchmark index. A large deviation in performance suggests the ETF is having structural problems delivering index performance.

In the world of institutional investing where every basis point counts, tracking error is a chief concern. The illustrative example below highlights that a greater compounded return can be achieved with a small smaller tracking error. Figure A compares four funds with varying degrees of negative tracking error that track the same benchmark index over a 10 year period.

Figure A

FOR ILLUSTRATIVE PURPOSES ONLY

	Initial Investment	Annual return of benchmark index	Annual tracking error	Terminal Value*	$ Difference vs Fund A Terminal Value
Fund A	1,000,000	10%	(0.07%)	2,701,164.35	–
Fund B	1,000,000	10%	(0.15%)	2,679,635.30	($21, 529.05)
Fund C	1,000,000	10%	(0.30%)	2,639,729.64	($61,435.71)
Fund D	1,000,000	10%	(0.45%)	2,600,418.10	($100,746.25)

*Compounded daily return over ten years

Source: Horizons ETFs

Some passively-managed fixed-income ETFs which track very thinly traded markets such as Canadian corporate bonds or preferred shares can see significant tracking error resulting from difficulties in buying and selling of the underlying securities when the index needs to rebalance. In these cases using an ETF or low-cost mutual fund that employs an actively managed strategy may deliver better risk-adjusted performance, since the managers are not constrained in when or where to buy the securities for the portfolio.

5. Volume is not the same as liquidity

There is a misconception that if an ETF does not trade a lot of shares on a daily basis that is has poor liquidity, meaning the value of the ETF may not reflect the market value of the underlying securities it tracks or holds. This is simply not true.

All of the major ETF providers in Canada have market making agreements with third-party financial institutions which ensure that the bid/ask spreads on ETFs remain low and that the net-asset value of the ETF reflects the market value of the securities.

An ETF could have trading volume of zero and an investor could still buy and sell a considerable number of units of the ETF for a price that approximates its net-asset-value per unit at that time.

Generally, the only factor which could affect the liquidity of an ETF is the liquidity of the underlying portfolio securities in the ETF. That is to say, if the ETF invests in securities that are difficult to buy or have low supply, then the market maker may have difficulty buying or selling those securities which could affect the ability of the ETF manager to issue or redeem units of the ETF.

An ETF that invests in liquid securities should have more than sufficient liquidity itself. If you find the right ETF and it has a low volume but invests in a liquid market, do not let that deter you from buying the ETF.

By following these five guidelines, investors can avoid most of the structural problems they could encounter when selecting an ETF. Hopefully by following these rules, you can greatly reduce the list of ETFs you will need to look at in order to find the one that works for you.

Howard Atkinson, CFA, CIMA, ICD.D, is the president of Horizons Exchange Traded Funds and author of four books including The New Investment Frontier III: A Guide to Exchange Traded Funds for Canadians, (Insomniac Press, 2005) and Les Fonds Négociés en Bourse: Un outil de placement novateur pour l’investisseur avisé (Transcontinental, 2003).