« Gorman will succeed Mack as CEO of Morgan Stanley | Home | GLD ETF and Fake Gold Conspiracy Theories (by Zeal_LLC) »
The Five Keys to ETF Differentiation (by FundQuest)
By Rob | September 24, 2009
Dear all,
Below is an interesting article that was sent to me today.
Two points I like to add:
1. I disagree with # 5 below,
2. I also believe that the Top-7 ETF providers are rather very capable at differentiating their products. It is when their wholesalers and marketing materials open the door that they start struggling, which is a sign of insufficient training and understanding of adviser’s priorities.
The Five Keys to ETF Differentiation (Daphne Gu)
The rapidly evolving exchange-traded fund landscape offers a wide set of solutions for retail investors. However, the frequent introductions of new and innovative ETF products pose a growing challenge for today’s financial advisors. It’s evident that ETF sponsors can improve their position in the market by providing data that helps advisory firms to efficiently evaluate the complex array of ETF choices.
Research confirms that the complexity of the ETF marketplace is a serious issue for advisors. Nearly 70% of advisors cited “unknown, untested indexes” and “the overwhelming number of choices” as the greatest disadvantages of ETF investing, according to a joint study by State Street Global Advisors and Knowledge@Wharton published in June 2008.
As of August 31, 2009, there were 858 different ETFs available in the U.S. with $674 billion in assets, according to Morningstar. The quantity of choices can be daunting, and considerable analysis is necessary to identify the best candidates.
Five Main Factors of Analysis
ETF sponsors can increase their market penetration by making information on these critical evaluation factors easily accessible to advisory firms. The five primary factors that need to be considered in evaluating traditional index based ETFs are as follows:
1. Understanding the Indexes
Advisors will need to understand the index to which an ETF is benchmarked. There are tens of thousands of global indexes and close to 6,000 indexes covering the U.S.-dollar-denominated global stock markets alone, according to Morningstar’s database. Three key elements to evaluate for each index include:
• Weighting scheme (price, market capitalization, dividends, etc.)
• Selection process (committee or rule-based)
• Frequency of rebalancing and reconstitution (quarterly, annually, etc.)
Because of these three elements, indexes representing the same investment category can perform very differently. For example, the S&P 500 Equal Weighted Index and Russell 1000 Index are both broad large-cap indexes. The S&P 500 Equal Weighted Index is equal weighted, has a committee-based selection process, and is rebalanced and reconstituted quarterly. Conversely, the Russell 1000 Index is market cap weighted, has a rule-based selection of stocks included, and is rebalanced and reconstituted annually. Advisors will recognize that these variations may lead to quite different risk and return profiles. ETF providers can provide a valuable service by explaining the relative advantages of how their product’s underlying index is formulated.
2. Performing Quantitative Analysis
Quantitative analysis focuses on tracking error (to index), expenses, tax efficiency, risk-adjusted return and sector allocation. Holdings-based style analysis and upside/downside analysis are two valuable tools that advisory firm professionals can employ. This type of analysis reveals that the differences between similar types of ETFs can be substantial and significant. ETF providers can help by providing easy access to the information that is needed to complete these types of quantitative analysis.
3. Qualitative Analysis of the Offering Firm
As noted above, many new firms have entered the ETF marketplace. Some providers (Vanguard is one obvious example) have a heritage of index-based investing. Others have little or no experience managing index-based products and may merely be testing the water with ETFs. New entrants should anticipate careful scrutiny by advisory firms and should clearly communicate the relevance of their credentials and expertise.
Quite a few firms have exited the ETF market over the past year. Astute advisors will assess the possibility that a provider will exit the ETF business due to an inability to gain significant assets. Investors do not want to be in a position where they are forced to sell (redeem) ETF shares due to product closures and possibly endure tax consequences.
4. Liquidity and Trading Volume
Unlike traditional open-end mutual funds, ETFs generally provide investors with greater liquidity due to the ability to trade intraday. However, the liquidity of the underlying securities in the ETF needs to be evaluated and the trading volume of the ETF itself also needs to be considered. ETFs with low trading volume may trade at a premium or discount that may impact performance. While liquidity is very difficult to assess, advisory firms are becoming increasingly sensitive to this issue and providers should be prepared to be proactive with information about liquidity.
5. Identifying the ‘Best Fit’ ETF for an Investor’s Portfolio
There are a number of key questions to answer when determining if an ETF is the “best fit” for an investor’s portfolio. Does the ETF provide the investor with the best opportunity to achieve desired exposure to an investment category? Would multiple ETFs accomplish the desired result, or is a blend of active and passive investments advantageous? If a combination of active and passive investments is used, then it is important for an advisory firm to determine the optimal blend - the different percentages allocated between active and passive investments within the investment category. This analysis is difficult, and many advisors will seek expert assistance.
Conclusions and Other Categories
Remember that the differences between seemingly identical ETFs can be quite substantive and, as a result, advisory firms selecting ETFs will need to conduct significant analysis. ETF providers can help by being proactive in providing critical information. Please note that this point of view is only an introduction to the main factors that advisors and investors need to consider and addresses the “traditional” passive ETF category in which the bulk of the industry’s assets are invested. Other categories, including sector ETFs, leveraged ETFs and actively managed ETFs, will each have a different set of critical factors to evaluate.
If you enjoyed this post, make sure you subscribe to my RSS feed!
Topics: Uncategorized |