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Assessing the New Generation of ETFs

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Over the past decade, the ETF industry has expanded dramatically, not only in assets under management, but in product innovation as well. In response, investment advisors looking to profit from the next generation of U.S.-listed ETFs must evolve in the manner by which they assess these funds.

In the early part of the last decade, the ETF industry was relatively homogenous, offering fewer than 100 products that provided transparent exposure to broad equity indexes and sectors. Differences between the underlying indexes within a given segment of the market were relatively small and had only minor impacts on relative performance. As a result, it quickly became “conventional wisdom” to focus on cost comparisons when sifting through the list of available ETFs. For especially savvy investors, this included an assessment of trading costs, in addition to internal fund expenses.

However, as the number of U.S.-listed exchange-traded products approaches 1,500 in 2012, simple cost comparisons are generally inadequate to determine which ETF best fits an investor’s objectives. While there is no doubt that cost has a concrete impact on net performance, as ETFs become more differentiated, there are more important factors to be considered. As a starting point, there are three core questions that should be asked in addition to (and often before) considering cost comparisons.

What underlying instruments are being utilized to provide exposure to a given segment of the market, and is this an ETF or another type of exchange-traded product?

When analyzing a group of ETFs, investors should first identify, and recognize the nuances associated with, different types of underlying investments. For example, exposure to commodities can be achieved via futures contracts, physical storage or related equities, which may be packaged as a traditional 1940 Act ETF, an exchange-traded note or a limited partnership. Each has its pros and cons and may provide vastly different results, not to mention tax implications, so investors should carefully evaluate which type of exchange-traded product best fits their objectives.

How are stocks or other instruments selected, weighted and rebalanced in an ETF?

Unlike the plain vanilla equity-index ETFs from a decade ago, which were generally market-cap weighted and whose holdings within a given market segment were often nearly identical, more recently launched ETFs follow indexes with vastly different methodologies, meant to pinpoint exposure to various industries, themes or strategies. Even within a broad equity category, like large-cap value, there are currently 39 different ETFs from which to choose (according to Morningstar), each following different indexes and providing different results. The most significant dissimilarities among equity indexes are generally found in the rules by which holdings are selected, the guidelines for weighting those holdings and the frequency by which they are rebalanced.

Why is an investor attempting to gain exposure to a given segment of the market?

The investment thesis that motivates an investor to consider a specific group of ETFs is generally the most important factor in determining which fund will provide the best fit. Take, for example, a portfolio manager with a bullish outlook on the financials sector. In order to select the ETF that best represents his opinion, he must now also consider whether this positive view applies to all financial institutions, or whether it’s more applicable to companies of a certain size, in a certain part of the world or from a specific industry within the sector, each of which may be tracked by a different ETF. As the number of ETFs has increased, so has the specificity by which a portfolio manager can use ETFs to express his convictions.

While cost-based comparisons reigned supreme in sorting through the first generation of ETFs, investment advisors now have an opportunity to add value to the investment process by basing ETF recommendations on attributes that may have a much greater impact on relative performance. Cost should certainly be included in that analysis, but its importance must be weighed appropriately. To some, the process of sorting through the ever-expanding universe of ETFs may seem daunting, but for those willing to look below the surface, the diversity of approaches employed by the new generation of ETFs provides valuable ingredients for efficiently building a well-diversified, low-cost investment portfolio.


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