The importance of doing ETF due diligence, given the rapid increase in the number of exchange-traded funds in the marketplace in recent years, cannot be stated enough. There are over 1,900 ETFs in the United States alone, which makes selecting an ETF from such a vast universe that much more time consuming and overwhelming.
Even before picking an ETF, it is important to construct your portfolio by focusing first on broad strategic asset allocation based on a myriad of factors including your return expectations, risk tolerances, time horizon, liquidity needs, tax considerations and any other unique issues/circumstances pertaining to your situation. This step is followed by diversifying across sub-asset classes. Your next focus should be on the type of ETF you desire based on your strategic asset allocation, whether that is exposure to a particular asset class, sector, theme, country or investment style/strategy.
Below we provide a framework that allows you to isolate the ETF that best fits your needs. A similar framework may be used for tactical asset allocation, which actively adjusts a portfolio’s asset allocation to improve the risk-adjusted returns of passive management investing.
Index and ETF
- Do you understand the investment objective of the ETF? Is it a passive strategy or an active strategy? Does the investment objective correspond with the contents of its portfolio?
- How long has it been since the inception of the ETF? What is the index the ETF is tracking? If it is an active ETF, how does it add value when compared to its index? In which market environments do active-ETF strategies underperform or outperform?
- How can you evaluate the manager: his/her broad index expertise, his/her commitment to indexing and his/her ability to execute on the investment objectives of the ETF?
- How concentrated are the ETF holdings? What type of exposure does the ETF give to particular sectors, companies and/or countries?
- Does the index and ETF report holdings daily, or less frequently?
Fund Provider
- What is the firm’s level of investment expertise, experience, track record and level of commitment to the ETF industry? Does the firm have a vision about the development and evolution of the industry?
- What is the firm’s level of experience in developing, growing, managing and supporting ETFs?
- What is the firm’s business and service models? Are they focused on supporting financial advisors? Are they focused on providing trading support and investor education?
- What type of risk management processes does the firm have in place?
- What are the firm’s total assets under management, as well as total ETF AUM? How do these values compare to their competitors’ AUM values?
Product Structure
- How is the ETF structured? How is it regulated?
- What type of securities does the ETF hold? What is the selection criteria and process for picking individual securities within the ETF?
- What are the fund’s top holdings?
- What index methodology does the ETF use (market capitalization, fundamentally weighted, price weighted, equal weighted)? How often is the ETF rebalanced?
- Does the ETF employ derivatives or leverage as part of its strategy? If so, what are the guidelines? Historically, how have these guidelines affected the ETF pricing and liquidity during market stress/volatility periods?
- What are the diversification guidelines for the ETF?
- How well does the ETF track its benchmark? Historically speaking, how large/small has the difference between the index’s return and the ETF’s return been?
- How does the creation/redemption process for the ETF impact tracking error? How does this process minimize bid-ask spreads, market impact and other transaction costs?
- What are the tax implications of the ETF structure?
- Does the ETF lend securities? If so, then what is the collateralized process like? How is risk managed in this scenario?
Cost
- What is the expense ratio of the ETF?
- What are the trading costs (commissions) and the average bid-ask spread of the ETF?
- What is the tracking error of the ETF? How has it changed over time?
- How are internal transaction costs such as trading costs, turnover costs, rebalancing costs etc. managed and minimized?
- What is the true total cost (both explicit and implicit costs) of the ETF ?
- What are the historical capital gains distributions of the ETF?
Liquidity
- What is the ETF’s average daily volume?
- What is the average daily volume of the ETF’s underlying securities?
- How does the ETF maintain liquidity?
- How has liquidity of the ETF been impacted historically during times of stress or market volatility?
- How do the bid-ask spreads of the ETF fluctuate over time? Does trading activity cause large swings in ETF pricing?
- What type of support services does the ETF provider maintain for liquidity? Does the ETF provider offer resources to help achieve best execution for clients?
The Bottom Line
ETF due diligence is an extremely important step towards successful ETF investing. You can utilize the above checklist as a guide to select the ETF you want to isolate and invest in to meet your investment goals. Just as with any other investment product, monitoring and evaluating the ETF you choose on an ongoing basis is crucial.
