Exchange-traded funds that follow the same index should provide almost identical returns. But they don't, thus complicating the financial adviser's job of choosing among the 1,000-plus ETFs for sale in the United States.
Because many competing ETFs have the same expense ratios, experts recommend that advisers look beyond fees and other costs associated with the funds to determine which ones can give investors an edge.
“Too often, investors buy based on the name of the ETF and not based on the exposure of the ETF to the underlying benchmark,” said Richard Genoni, head of ETF product management at
The Vanguard Group Inc.
One important factor that financial advisers should take into consideration when choosing between similar investments is how closely an ETF's portfolio mimics the underlying index, ETF trackers said.
Some funds replicate the index fully by containing all the same securities, and in the same proportion, as the underlying index.
In some cases, however, where the index is too large or some of the securities can't be bought and sold easily, the ETF will be designed using index optimization. With this technique, the ETF holds a representative portfolio of the index securities.
The more an ETF is optimized, the greater the risk of tracking error, which is the difference between the return of the index itself and that of the ETF. Most investors prefer full replication because if they are buying an index fund, they simply want the return of the index, not the added risk of owning an investment that outperforms or underperforms the index, said Matt Hougan, publisher of IndexUniverse.com.
“Always look at the history of tracking error of particular ETFs,” he said. “If you want to try and beat the index, you want an actively managed ETF.”
With an active ETF, managers buy and sell issues for the fund according to their own strategies, not based on an index.
In a comparison of two ETFs that track the MSCI Emerging Markets Index, the Vanguard Emerging Markets ETF Ticker:(VWO) contains all 748 securities in the index, and the iShares MSCI Emerging Markets ETF Ticker:(EEM) contains 719. EEM optimizes the ETF to make it more liquid and tax efficient but ends up underweighting certain areas, such as India, Mr. Hougan said.
The tracking error for EEM was 6.92% for the 12-month period through Sept. 30 and 7.02% over the three-year period, according to data from Morningstar Inc. For the same time periods, VWO's tracking error was 5.27% and 5.78%.
Through Sept. 30, EEM's return was 16.8%, -1.51% and 11.5% for the one-, three- and five-year periods, respectively. For the same periods, VWO's returns were 19.34%, -1.64% and 12.14%, according to Zephyr Style Advisor data provided by Vanguard.
At iShares, the global leader in ETFs, the amount earmarked for securities that may not be easily traded is an especially important consideration when dealing with emerging markets, said Kevin Feldman, a managing director of iShares, which is the ETF division of
BlackRock Inc.
MAKING ETFS LIQUID
The firm uses a mix of American depositary receipts — which trade on U.S. exchanges and represent shares of foreign companies — and actual shares to make ETFs more liquid, he said, noting that the additional liquidity is especially important to institutional investors who regularly need to trade large volumes.
Mr. Feldman noted that iShares manages more than 430 ETFs and said it is “the most experienced company in building these products to deliver the index.”
In the case of these two emerging-markets ETFs, both are very liquid in practice, Mr. Hougan said. However, he said, when considering any fund, liquidity is important because even if two funds have identical expenses, it can cost investors more to trade an illiquid ETF.
Experts recommend that advisers look at expense ratios, which measure the cost to run the fund, before deciding which ETF is right for customers, Mr. Hougan said. These expenses are taken out of ETF assets, thus lowering returns.
Typically, ETFs with the most complex strategies carry the highest expenses. The expense ratio for iShares' EEM is 0.72%, while Vanguard's VWO carries a ratio of 0.27%.
Other features advisers should examine are the ETF's capital gains distribution history and whether it has a share-lending policy allowing the fund to lend shares to short-sellers for a fee, Mr. Hougan said. This feature can boost the fund's return above that of its peers, he said.
LIKE PICKING A STOCK
Thomas S. Mench, chairman and chief investment officer of Mench Financial Inc., has used ETFs for more than a decade. He praised them for adding diversification at a low cost, but said that choosing which ETF is as crucial a decision as picking a particular stock or mutual fund.
“ETFs are not a panacea,” said Mr. Mench, whose firm manages $200 million in assets. “You still have to make a good decision on which to include.”
Mr. Mench starts his evaluation of an ETF by reading the prospectus carefully and examining the costs. The firm reviews the fund for a full year to make sure that it performs as expected, he said.
The firm also makes sure that the ETF has enough trading volume to allow it to sell $20 million of the offering in a day.
“We want to execute that trade with a 3-cent spread, whether it's the first person who buys it or the last,” Mr. Mench said.
