Doing the right due diligence when investing in ETFs

Exchange traded funds have revolutionized — and continue to transform — the way advisers construct portfolios for their clients.

Sep 4, 2019 @ 12:01 am

By Evan Cooper

Instead of researching individual issues or trying to find highly ranked active mutual fund managers, many advisers now often choose a few broad ETFs to track the entire equity and/or fixed-income market and then add selected, narrower ETFs to represent other key sectors.

In effect, these advisers have changed their value proposition. Instead of trying to outperform the market, which can be extremely difficult to accomplish over the long run on a net-of-expenses basis, advisers now add value, at least in part, by managing portfolio allocations and risk exposure, which can be done efficiently and economically by using exchange traded funds.

Along with this shift has come a change in advisers' due diligence responsibilities. In order to assure that their ETF choices meet stringent suitability and fiduciary standards, advisers must understand how the ETFs they choose are constructed and whether they meet a client's objectives and goals. In short, they have to know what's going on under the hood, and not recommend an ETF simply because its name appears to satisfy a portfolio allocation.

Since the information needed to perform the proper due diligence on an ETF is contained in its prospectus and in documentation from the fund sponsor, an adviser's key job is knowing what to look for and what questions to ask. Here is a five-part ETF due diligence checklist/questionnaire that can help advisers ensure that the ETFs they recommend truly meet clients' needs.

1. The underlying index

  1. How long has the index existed and who manages it? An index provider's reputation and tenure can indicate stability.
  2. Does the index measure the broad market or a sector, companies or countries? Understanding the focus allows an adviser to pinpoint a client's portfolio and risk exposure.
  3. Weighting. Whether by market capitalization, price or some other measure, index weighting methodologies can lead to differences in performance and risk/return characteristics among seemingly similar indexes.
  4. Frequency of component change. Adding or removing index components too frequently can increase trading costs, which reduces investors' returns.

2. The sponsor/provider

  1. Size, reputation and experience. Large, well-established firms with long ETF histories and sizeable ETF assets under management demonstrate stability and commitment, as well as a track record of working with index providers and advisers. Greater AUM can also enhance an ETF's liquidity.
  2. Trading support and ongoing education. Sponsors that provide timely, actionable investment strategies help clients and advisers alike.

3. The ETF's structure

  1. Narrow or broad? A greater number of holdings means increased diversification for the client.
  2. Does the ETF hold the entire index? Some ETFs fully replicate an index while others don't. This can affect how closely an ETF tracks its index and how well it suits a given portfolio.
  3. Tracking error. Ideally, an ETF should move in sync with its index, showing little or no difference from the index's long-term return. It's important to note that calculating tracking error incorporates the expense ratio, the portfolio management efficiency in seeking to match the index returns and the positive offset of any income from lending out underlying securities of the ETF.
  4. Is what you see what you get? Some ETFs fully track the index in their names, but other names belie their actual holdings. Advisers must examine the fund's underlying securities to see if the ETF delivers what it promises.
  5. Do the ETF's holdings overlap significantly with a client's other portfolio holdings?
  6. Legal format. Different structures — unit investment trust, open-end fund, grantor trust, exchange traded note — can lead to differences in how an ETF manages risk and liquidity, as well as in how it is taxed.
  7. Does the ETF lend securities? If so, what is its collateralization process and how is risk managed?

4. Costs

  1. What is the fund's total expense ratio? Lower, of course, is better.
  2. What are the trading costs (commissions and transaction fees) associated with buying the ETF shares?
  3. Average bid-ask spread. Wider spreads often indicate less liquidity and higher trading costs. The difference in the trading costs of two ETFs' often outweighs the difference in their expense ratios. This makes liquidity analysis an important part of the due diligence process.

5. Liquidity

  1. Average daily volume. Active trading can mean greater liquidity and better pricing.
  2. Underlying share liquidity. At times of market stress, authorized participants (the market professionals who create and redeem ETF shares) may have trouble sourcing liquidity for thinly-traded securities. At such times, ETFs consisting of these shares may incur higher trading costs or see their own liquidity decline.
  3. Dramatic price swings? Small volume changes causing large bid-ask spreads could indicate liquidity concerns.

With more than 2,200 exchange traded funds now in the US marketplace, adviser due diligence is more important than ever.

Important Risk Discussion This material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. State Street Global Advisors and InvestmentNews are not affiliated. ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as “creation units.”Brokerage commissions and ETF expenses will reduce returns. State Street Global Advisors Funds Distributors LLC member FINRA SIPC. Exp date 8/31/2020 2674740.1.1.AM.RTL


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