From the July 2015 issue of Investment Advisor • Subscribe!

Know Your ETF Constituents

Changes in ETF managers and strategies aren't the only things that can impact your clients’ risk exposure

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Advisors need to pay attention to changes in an ETF's underlying index, just as they do to changes in managers or strategies. Advisors need to pay attention to changes in an ETF's underlying index, just as they do to changes in managers or strategies.

Incorporating ETFs of any sort into a portfolio offers efficiency on many fronts, including better diversification, an easier client user experience and better leverage of a financial professional's time devoted to tasks needed to maintain and grow a practice.

Being in the actively managed ETF space, we understand that advisors must pay close attention to manager changes and strategy changes. However, some advisors may not realize that they need to take the same care and due diligence regarding the construction of newly created indexes, as well as when an ETF sponsor decides to change an underlying index for a fund.

In late May, a curious price action occurred in the stock of Hanergy Thin Film Power Group, a Chinese solar company whose primary listing was on the Hong Kong Stock Exchange. After more than a 500% share price gain in less than one year, the foreign stock fell 47% in a matter of minutes on May 20. By virtue of its explosive growth, Hanergy had come to have a 12% weighting in a solar-themed ETF. While the stock's meteoric ascent contributed to that ETF's rise, the trading on May 20 led to an approximately 7% single-day drop for the fund. Awareness of any individual stocks with positions large enough that can cause such a significant decline for a fund is a crucial part of successfully implementing an ETF strategy.

In August 2012, Vanguard removed the MSCI index that underlay its emerging market ETF and replaced it with an emerging market index from FTSE. Interestingly, the same MSCI index still underlies iShares’ emerging market fund. Since the switch, the difference between the two indexes has been meaningful. For the 12-month period ending April 30, the fund tracking the FTSE index outperformed its counterpart by 335 basis points.

The two indexes have differences in country and sector weightings, which likely account for the dispersion. For example, the FTSE index omits South Korea, a country market that has underperformed over the last year and has a large weighting in the MSCI index. It's critical that advisors understand how a fund's underlying index is constructed, and that they stay informed of any changes to an index to successfully implement the level of risk clients are willing to take in their investments.

It has been almost one year since Bill Gross resigned from PIMCO. He, of course, has been known for many years as the “Bond King,” co-founded PIMCO and managed numerous funds across various product structures—ETF, closed-end fund and traditional mutual fund—for the firm. Since Gross’ PIMCO departure, both the ETF and traditional fund versions of the Total Return fund he was most known for have lagged behind the Barclays Capital Aggregate Index. In the year before his departure, the ETF outperformed while the traditional mutual fund lagged.

So much was written, discussed and analyzed about the Gross resignation. Many investors understood this was a trigger to reconsider their allocation to the strategy. Some investors had concerns and redeemed, while others felt comfortable with the existing team and chose to stay in the strategy. It seemed clear that many fiduciaries understood their role was to look closely at their clients’ allocations and make a decision on their behalf.

We do not see this happening with index ETFs as not all broad market exposure is the same, and returns and risk profiles can be very different from each other. While ETFs have blurred the lines for index investing by dramatically expanding what can be defined as an index, one thing is becoming more certain: Advisors are learning to treat new index ETFs similarly to active strategies, and to know which underlying ETF constituents their clients own.

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