Increasing activity in licensing indices is leading to a greater choice of ETFs. But how do investors differentiate between the rising number of similar products? Matthew Craig reports
In an old-fashioned sweet shop, eager children could spend their pocket money on a bewildering selection of confectionery which came in various flavours, sizes, shapes and colours. Much time could be spent deliberating on the merits of gobstoppers, black jacks, white mice or sherbet dips.
Now ETF investors can face a similar agony of choice. According to BlackRock global head of ETF research and implementation strategy Deborah Fuhr, there are now more than 30 Eurostoxx 50 ETFs open to European investors. But as with the vast array of sweets, buyers ultimately want to make a choice that suits their particular tastes.
So how should investors decide between the multiple ETFs tracking the same index? Talk to index providers, ETF managers and other experts and a number of themes emerge. One is the importance of doing the necessary due diligence and really understanding both the index in question and how the ETFs that track it can vary.
But perhaps the most obvious factors affecting choice are brand name and first mover advantage. Fuhr said: “Once people start using a product it is a challenge to get them to move. Going to the compliance team and asking them to sign off on a new product can be a lot of work.” Indeed, market acceptance of a brand has a significant influence on the selection process.
Similarly, the notion of index recognition is important. Vanguard Investments UK head of retail Peter Robertson said: “The reality is that UK investors investing in UK equities will use the FTSE All Share or FTSE 100 indices. The choice of indices is as much about pragmatism as anything, rather than saying one index is better or worse than another”.
As well as brand recognition, Fuhr at BlackRock said ETF providers differ in their philosophy, the type of products they offer and the service behind the funds, right down to fact sheets, websites and sales support; all of these factors could sway investors.
At the same time, there are fundamental issues to consider, such as the index itself. Ken O’Keeffe, Russell Investment’s regional director for ETFs based on the firm’s indices, said investors should ensure that the indices they seek to track are rules-based, transparent, offer the best beta capture for the asset class or sector, and are investable.
Having a rules-based methodology for calculating an index means that there is a rational, scientific approach behind the index. Often, index providers will make their methodology publicly available so investors can examine it. This transparency should provide comfort to investors and give an index greater credibility.
It is important that an index is investable, so that ETFs and other index-tracking products can replicate it efficiently. However, MSCI head of index business Theodore Niggli said there is always a trade-off made by index providers between the extent to which an index represents the respective market, and the level of investability, allowing investors to buy shares intra-day without facing liquidity constraints.
Where a number of ETFs follow the same index, investors can compare their respective tracking error rates to see which fund tracks an index the closest. It should be noted here that swap-based ETFs normally have the lowest tracking error. Manooj Mistry, head of db x-trackers UK, said: “We always want to make sure our products have the most efficient tracking, which is why they are set up to use synthetic replication. In the worst case, the maximum tracking error is the total expense ratio (TER) and where possible we bring in enhancements to improve performance further.”
While swap-based ETFs may be able to track an index almost perfectly, TCF Fund Managers joint founder and chief executive officer Gary Mairs said investors should look at the collateralisation arrangements involved. He said: “The risk of tracking error is replaced with credit risk on the counterparty and the swap, so investors need to evaluate which method is appropriate. This kind of thing requires quite careful analysis.” Similar questions apply around stock lending, when a fund manager earns a fee by lending stock to third parties.
Other factors to consider
As well as looking at the index methodology, investors comparing ETFs based on the same benchmark should consider where a fund is domiciled and where it is registered for sale. For UK investors, it is important to know if an ETF has distributor status under the old tax rules, or is classed as a reporting fund under the new rules, as this will have tax consequences. Mistry said: “Another consideration, depending on whether investors are retail or institutional, is whether an ETF is authorised for distribution in a country.”
Investors need also to understand ETFs can differ in their structure. Fuhr asked: “How do they do creations and redemptions? How many market makers do they have? The structure around a product is very important.”
Product fees are another consideration, as is the bid-offer spread. The spread will vary according to factors such as the size of the fund and the underlying market liquidity. According to Mistry, spreads can typically range from four to 19 basis points for an ETF tracking the FTSE 100 index depending on the provider.
When it comes to differentiating between ETFs using the main market indices, Mairs said that although providers try to compete by offering something slightly different, it would be better for investors if providers concentrated on doing the basics well, at a lower cost. He said: “I am not sure that the industry is operating in that way. It is not obvious that the massive proliferation of indices is helping the customers. Do most innovations really benefit the customers or are they really to give more opportunities for sales and marketing teams?”
Indeed this conjures the debate about the value of indices using alternatives to the traditional weighting of constituent stocks by market capitalisation. O’Keeffe said: “Equally or fundamentally weighted indices capture the beta of these strategies and that is different to the beta from traditional market cap weighted indices. In many cases, the historical performance is higher than market cap weighted indices, with a roughly similar standard deviation of returns.”
O’Keeffe added that factor-based indices, momentum-oriented indices and low volatility indices are all areas which will see more activity, as ETF providers innovate and strive to find sources of beta for investors that complement market cap indices.
On the other hand, MSCI’s Niggli said only two types of thematic indices have gained traction in the last few years: inverse and leveraged indices underlying ETFs and those comprising stocks paying higher dividends. He added: “There have been a slew of indices on themes such as fundamental weightings, but I haven’t seen ETF assets flow to them that much.”
One issue is that in some markets, such as fixed income, having a market cap weighted index might not be considered entirely beneficial. Mairs said: “A bond index could be concentrated on companies that issue a lot of corporate bonds, so you could argue that it becomes more biased to more risky and indebted companies.”
It is possible for index providers to work with fund managers to create bespoke ETFs, although views vary on this. Niggli said: “We launched an index called FX Hedge, working closely with the FX team at Deutsche Bank, which is being used for over-the-counter trades, and we hope to see an ETF on that in the future. Similarly, we are working with other parties to come up with innovative methodologies. But in all cases, because these are MSCI branded indices, we are in full control of the ongoing management and licensing of the index.”
Look before you leap
However, Mairs sounded a note of caution: “Where product providers commission index providers to come up with an index, investors need to be very careful. Is there a vested interest in a bespoke index? There may be a conflict between what’s right for an investment bank and what’s right for investors.” But O’Keeffe added that leading index providers would not do anything to harm the integrity of their brand when creating a bespoke index.
There are a number of factors investors should consider when they have a choice of ETFs tracking a market index. It is important to look at the index itself and its merits as a benchmark for investors. With index providers licensing more and more indices for ETFs, the debate over where to invest will go on, so investors need to look at the complete picture.
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