Choosing ETFs: My Ten-Point Checklist

by: IndexUniverse Europe

By Paul Amery

In response to Matt Hougan's latest post, costs are certainly not everything, and neither are headline fund fees the full story, even though the cheapness of ETFs is undoubtedly their main selling point. Here’s my attempt at a ten-point checklist.

I’d want to run through it before going ahead and buying an exchange-traded product, and I've written it with a general reader in mind.

Some parts (for example the sections on tax and investment adviser platforms) are written from a UK perspective, but the rest is not UK-specific.

1. ETF, ETC, or ETN?

While the majority of European exchange-traded tracker products are ETFs – which means they are set up and regulated like funds – Europe also has an active exchange-traded commodity (ETC) and exchange-traded note (ETN) market. ETCs and ETNs are used to track single commodities, or other, less-diversified asset classes, which cannot be structured as ETFs under the relevant European investment fund regulations.

What’s the difference? ETFs, ETCs and ETNs are all low-cost savings vehicles that track asset prices or indices. But ETFs are funds, meaning that, in the case of the bankruptcy of the promoter, assets should be safeguarded by a separate fund custodian.

Many ETNs and ETCs are collateralised, meaning that there are securities, cash, or, in some cases, physical commodities backing your savings product. Other ETNs or ETCs may not have such backing, which means that you are an unsecured creditor of the issuer and at risk if the latter runs into trouble. Check the issuer’s website and prospectus to see if there is a collateral mechanism and how it actually works.

2. Swap-based or physical replication?

Some ETFs (including most of those offered by the industry leader, iShares) use physical replication to reproduce the index return. This means that the fund manager buys all the shares, bonds or other securities in the index, or an optimised sample of them, and holds them within the ETF.

The majority of European ETF providers, however, use a process called swap-based replication. This means that an ETF will hold a basket of securities (called the collateral basket) which is unrelated to the index being tracked, and will enter into a swap contract with a third party (usually a bank and often the parent bank of the ETF issuer) which guarantees to pay the ETF the return on the index it is tracking.

Physical replication can cause tracking error, as the result of index turnover costs and the timing or tax treatment of dividends. Swap-based replication eliminates the tracking error to the index, since the swap provider guarantees to pay the full index return, but at the cost of limited counterparty exposure to the bank concerned.

Why does an investor need to know this? The rise in bank default risk since the start of the credit crunch means that investors should certainly be aware of any counterparty exposures they incur, and the different methods of index replication mean that a comparison of ETFs purely on the basis of tracking ability cannot tell the full story.

This is actually a very technical subject, once you get into it, and it’s not as simple as swap-based ETFs being riskier than those using physical replication (as some have suggested), since physically replicating funds often lend securities, and this practice can have risks of its own, collateral notwithstanding. For what it’s worth, I’d be happy to have both types of ETF in my portfolio.

3. What’s the cost?

ETFs, ETCs and ETNs carry a charge called the total expense ratio, which includes the fund manager's annual fee and certain additional costs. The TER is usually much lower than that of comparable actively-managed funds. This is one of the chief attractions of ETFs. However, if you’re planning to be an active trader of an ETF, you should check its secondary market liquidity and historical bid-offer spreads. These can vary from a few basis points (hundredths of a percent) to well over one percent for ETFs in less-liquid asset classes, in which case trading costs would be very material when compared to the fund's management fees. You should be able to find this information on the website of your country’s stock exchange.

Other costs could arise if the fund were to close, or fail to grow. See point 4.

4. Chances of closure?

The recent closure of Spa ETF’s Marketgrader funds landed some investors with a bill of over 10% of fund assets when closure costs were charged to the funds. There are many ETFs out there that have not grown beyond a few million euros in size and may be vulnerable to being closed. ETF issuers may vary in how they handle any associated costs, but do a little research into how long the fund provider and fund has been going, and whether they have gained, or are likely to gain critical mass.

There may also be unamortised costs from the time of the ETF’s launch, which may be capped or absorbed by the sponsor for a period of time, but which could return as a real cost to investors, particularly if the fund doesn’t grow beyond a certain size. Check the prospectus.

We’ve also recently seen some delisting of certain Lyxor ETFs in the UK, also as the result of the funds’ failure to grow beyond a certain size. This is not the same as the closure of the fund, as the ETFs concerned continue to trade on other exchanges, but if you’re a UK-based retail investor you will have had your money returned to you and will have been forced to reinvest it, an inconvenience if you were planning to hold the investment for ten or twenty years within a pension plan, say.

5. How’s the index constructed?

Financial indices have a surprising variety of construction methods – from capitalisation weighting, price weighting, equal weighting, dividend weighting, to weighting by some factor-based model. Critics of capitalisation weighting argue that this method allocates too high a share of the index to overvalued sectors and stocks during market bubbles, and too little during slumps. There’s a vibrant academic debate still ongoing on this subject, which is worth following on the internet.

Other indices may produce surprising price effects. Commodity indices will be hit by a “negative roll yield” when future/forward commodity prices are above spot rates (this is called “contango”). If the market is in the opposite state – “backwardation” – and future prices are below spot prices, you get a positive return from rolling your investment from one contract to the next on a regular basis. If you don’t understand this effect, you shouldn’t really go near commodity trackers.

Leveraged indices, which typically track a multiple of the daily index return, will diverge from the same multiple of the index when measured over a longer period, and so leveraged ETFs are strictly for the trader and are not appropriate as long-term holdings. As I’m hopeless at market timing, I’d never invest in one, but good luck if you do.

For me this question – how the index works from an investment point of view - would probably rank as one of the key points to consider, once I’d decided to invest in a certain market or asset class.

6. Is it diversified?

Some indices cap individual stock weightings, others (typically capitalisation-weighted) can allow a single company or issuer to represent a major proportion of the benchmark. The less diversified, the greater the scope for volatility of return. Check the index factsheet on your ETF issuer’s website for details.

7. Is there a third-party index provider?

The existence of a third-party index provider should guarantee that the index returns are being measured fairly. Check that there is one, and who that is. This is not to say that ETFs where the parent bank is calculating the index have anything necessarily wrong with them – but history has taught us to pay attention to potential conflicts of interest within the financial industry.

8. Are there extra costs to hold within a SIPP, ISA, or investment adviser platform?

One leading SIPP (self-invested pension plan) provider in the UK charges a 0.5% annual fee to hold ETFs – more than doubling the average fee on the fund itself. What’s the point of switching your portfolio into low-cost ETFs if the company you use for custody immediately takes away the cost advantage? Investment adviser platforms may also charge fees both to buy and to hold an ETF.

With Vanguard’s recent launch of ultra-cheap index funds and some cuts by platform providers in their charges to hold either index funds or ETFs, there’s a lot of price competition going on right now. Shop around.

9. Does it suit my tax status?

If you’re investing from within a taxable UK account, you will want ETFs with “distributor” status. Since most ETFs sold in the UK are domiciled in established overseas fund jurisdictions such as Dublin or Luxembourg, such status would mean that gains made on ETFs are subject to capital gains tax, rather than income tax, which is a big advantage, given the different tax rates involved.

10. Have I considered all the alternatives?

ETFs slice and dice the available investment universe in many ways. If you want a representative equity portfolio you could combine country equity funds, make a selection of sector ETFs or go the large, mid or small-cap route. Bond ETFs can be organised by asset type, maturity band or credit quality. ETCs and ETNs can reach areas of the markets that ETFs may not be able to cover. Try to be aware of all the alternatives, before getting to the really difficult, but fun part - deciding which markets to invest in!

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