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Special Report: There’s an ETF for That: How to Pick a Winner

By Grace Williams June 18, 2019

New ETFs pop up every day, many simply replicating indexes that are already available. Part Two of our five-part ETF Masterclass Special Report examines how advisors can choose among them.

Once upon a time, a famous tech company coined the instant cliché, “We have an app for that.” But given the variety of the 2,000-plus ETFs out there to choose from, most advisors can confidently say, “We have an ETF for that” as well. And as with any bountiful buffet, picking what feeds an investors’ appetite is becoming an ever more difficult challenge.

Given the variety and redundancy within the space, advisors looking into ETFs now must sift through many more options to find the best products for their clients. This, naturally, will require patience and legwork, but these leaders in the industry think it’s more than worth it in the long run.

Lindsay Faussone, vice president of strategic programs at E*TRADE Advisor Services, cites several factors when selecting products. “We see advisors looking for a familiar provider, a large provider, and a trusted provider,” she says.

But what should advisors do when it’s homework time? The experts say you should consider the following:

Tracking Errors

“Some of those may be interesting, for a hot minute, if they have the names marijuana or blockchain, or AI in them.”
Elisabeth Kashner
Factset
One standard industry expectation of ETFs is that they closely track their index. But not all tracking is created equal. “Some of them don’t track an index as closely as others,” says Faussone. “You hear a lot about the tracking difference, which can impact the underlying performance of the client portfolio.”

While tracking errors can be relatively small, the impact can be felt and could result in a disgruntled client.

The best way to combat this potential hiccup is through solid research. This can be done by looking into the fund’s R-squared and beta. R-squared uses statistical measurements to indicate how the fund’s price movements correlate with an index. The closer it is to one, the closer its movements match the target index. Beta is a measurement tool that shows how much a stock is expected to move up or down each day related to the movement of the S&P. It helps with measuring the market and systemic risk of a security.

Transaction Costs

Faussone sees a trend where advisors tend to spend a lot of time going into quantitative evaluation, looking hard at aspects such as the expense ratio. Faussone points out that, while good, it won’t help clients if advisors aren’t looking at costs, which can “eat into” the return.

“With the transaction costs really having the potential to add up,” she says, “if the client is making periodic contributions or distributions that generate trade, there [could be] a significant cost element.”

By looking for commission or trading programs that help to minimize the other cost elements, advisors can minimize any hesitancy about production costs, or if portfolio changes are appropriate for clients. “You want to be thinking, ‘What’s the right investment for my client?’” she says.

Patient Strategy

Larry Swedroe, Buckingham Strategic Wealth
One school of thought is that investors can execute a strategy of patience using a combination of active and passive management. Larry Swedroe, principal and director of research for Buckingham Strategic Wealth, says the best funds for this are managed by portfolio managers who accept the risk of tracking errors versus a benchmark index. In return, they see lower trading costs which comes from being a provider of liquidity instead of a taker.

This lets investors minimize the negatives of an index, which Swedroe explains, “can be exploited easily by active managers who know in advance when the pure indexers must trade. So the way to address that is to trade patiently and use algorithmic programs to execute, and provide liquidity instead of paying for it.”

Swedroe says these strategies require tremendous patience and business discipline. “All risky assets go through very long periods of time of underperformance. And that must be true or there would be no risk,” he says. “All you have to do is hang on. [Investors] think three years is a long time to judge performance. Five years is a very long time. And 10 years is an eternity.”

Balance

Who among us hasn’t heard someone touting the hottest new products in the ETF space? Excitement is understandable, but are you willing to bet your clients’ financial well-being on it? Not so fast, says Elisabeth Kashner, director of ETF research and analytics at Factset. “Some of those may be interesting, for a hot minute, if they have the names marijuana or blockchain or AI in them,” she says. “But they just generally don’t get the kind of traction that the big, broad, simple funds do.”

To fully evaluate an ETF, advisors should get a better understanding of a fund’s long-term holding costs and risks, which entails looking at the expense ratio, legal structure, and tax treatment, plus fund closure risk and tracking difference, which Kashner says takes six months or more to manifest. “Costs, risks, and trading conditions should be monitored on an ongoing basis, as expense ratios can and do change, usually to the client’s benefit,” she says. “Tracking can shift, and trading costs will vary depending on market conditions.”

Next: ETF Strategy Masterclass: Asset Class, Sector and Regional Diversification