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?
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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.