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While ETF providers may be engaged in a price war, it’s important not to forget what these products are best used for
Thursday 12 Apr 2018 Author: David Stevenson

One of the great success stories in investment products has been the exchange-traded fund (ETF). Making its debut in 1993 in the US, today the ETF industry is worth trillions of dollars and new products are constantly being brought to market.

But what should an investor look at when choosing from the vast choice of ETFs on offer?

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WHAT IS YOUR EXPOSURE?

The starting point when choosing an ETF is to look at what it provides exposure to and how that lines up with your objectives.

This will mean looking at the index the product tracks and the accompanying documentation such as the key investor information document (KIID).

ETFs can grant investors access to a broad and diversified set of assets depending on the underlying index it tracks.

Hortense Bioy, director of passive fund research at Morningstar, says ‘the broader the better. The broader the index the harder it is for an active manager to beat it’.

For this reason she prefers the FTSE All Share to the FTSE 100 due to the greater amount of stocks in the former index.

For an extremely broad-based ETF, one that tracks a global index is a good fit, for example the MSCI World. Source MSCI World (SCOJ) and Lyxor MSCI World (WLDL) have constituent equities in several developed markets and can be useful as a core building block of a portfolio.

The MSCI World index consists of companies from 23 developed market countries and both of the aforementioned ETFs aim to provide the return of the index.

Given that these plain vanilla ETFs are market cap weighted, they are skewed towards the US. The Source and Lyxor ETFs have 50.5% and 36.9% of their holdings in the US respectively.

ETFs allow investors to express their own view of where the global market is going, in Bioy’s words, ‘ETFs are a democratic tool as opposed to giving your money to an active manager’.

Before the recent technology sector sell off following revelations about Facebook’s use of private data and US president Donald Trump’s attack on Amazon’s business practices, exposure to tech
heavy US equities markets seemed attractive.

Lyxor’s recently launched Core Morningstar US Equity (LCUS) has the above tech giants in its top ten, as well as its peers Google owner Alphabet and Apple.

One thing to be careful of is duplication as investors may already have exposure to popular stocks such as the US tech companies, dubbed the FANGs (Facebook, Amazon, Netflix, Google). Investors may hold the companies through holdings in the individual shares, in a mutual fund or as part of another ETF that tracks a global index.

Remember, if an index is market cap weighted then the largest companies will constitute a more significant part of it.

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A ROUTE TO DIVERSIFICATION

According to figures from iShares, the ETF division of asset manager BlackRock, March 2018 was not great for ETFs. In the final week of the month, $3.7bn was withdrawn from US equity ETFs and $3.4bn from European equity ETFs. Even broad developed market ETFs saw outflows, totalling $1.4bn.

Given the weak performance of major developed markets including the FTSE 100 at the moment, investors may wish to gain exposure to emerging markets instead.

Some might argue that investing in emerging markets
is so fraught with dangers that it is unsuitable for passive investing, and is better suited to active managers with stock picking skills.

But Morningstar’s Bioy argues a broad emerging market fund will outperform over the long term and these products are best suited to buy and hold investors.

 

Vanguard’s Emerging Markets FTSE (VFEM) top holdings include Tencent, China Construction Bank and China Mobile. Emerging market ETFs can also offer broad exposure and spread risk away from single countries.

An important point when choosing any ETF is to look at the index provider. For emerging markets, two of the largest index providers, MSCI and FTSE, have different views on South Korea. MSCI classes the country as emerging whereas FTSE views it as developed. Given the size of this market, this difference could have serious implications for returns.

IShares MSCI Emerging Markets (SEMA) is similar to the Vanguard product despite the differing index provider. The most glaring difference is that the top five holdings of both ETFs are identical apart from Vanguard’s ETF not including Samsung, a South Korean company.

THE COST FACTOR

When choosing an ETF, low costs are obviously part of the attraction but it would be wrong to base the entire decision on cost. Achieving the right investment outcome should remain paramount at all times.

Adam Laird, head of ETF strategy at Lyxor, says: ‘Lower is better although remember that cheap isn’t the same as right. A low charge can’t compensate for buying something that doesn’t fit your circumstances’.

Laird is in a good position to discuss costs, his firm Lyxor launched two ETFs recently that have the lowest fee in Europe at just 0.04%. The aforementioned Morningstar US Equity ETF and its Core Morningstar UK (LCUK).

One part of the cost equation that is often overlooked is trading fees. Less frequently traded ETFs may see a more significant difference between the price at which you buy and sell which
can add up over time and have an impact on returns. However,
if we assume that ETFs are buy and hold products and investors have a long investment horizon, this impact should be relatively modest.

The low fees for ETFs are also linked to economies of scale. ETF providers are looking to build assets under management (AUM) which then allows them to further lower fees, for this reason it might be sensible to go with larger providers if you can.

PHYSICAL OR SYNTHETIC?

Physical and synthetic replication refer to the method by which an exchange-traded fund achieves its tracking of a market.

Physically-backed products trade directly in the underlying stocks and shares in an index to replicate the performance of a market, while synthetic ETFs employ a swap-based method of replication, buying derivatives contracts offered by brokers and investment banks which artificially provide the performance of a market.

Synthetic products tend to be used when it is difficult to track a market through physical replication either due to a lack
of liquidity or restrictions on foreign ownership.

You might have heard of tracking error and this is something else that you need to be aware of when choosing ETFs, especially index-based ones.

It measures how far the performance of an ETF deviates from its benchmark. As ETFs are products constructed to mirror an index, the tracking difference and tracking error are particularly relevant considerations. The tracking difference is the performance
of the index minus the performance of the fund, while the tracking error reflects the volatility of the fund compared with the underlying.

Noting that its PowerShares S&P 500 (SPXS) has a charge of just 0.05%, Chris Mellor, head of equity and commodities product management at Invesco PowerShares says: ‘There isn’t much more we can do to reduce that, so instead we look for ways to incrementally improve the tracking.

‘Making sure our ETFs are competitively priced and have low tracking error should result in our investors getting more for their money. In our opinion, that’s a better recipe for growing AUM for the long term.’ (DS)

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