The 4 Biggest Problems in ETF Selection

24 October 2016  |  Simon Miller
The 4 Biggest Problems in ETF Selection
ETFs are great, but choosing between them isn’t straightforward.
Here are 4 of the biggest problems facing retail investors.

Exchange Traded Funds, also known as Passive or Index Funds, aim to track the returns of a given index without relying on a fund manager. Created by Jack Bogle in 1976 to enable direct investment into the American stock index – the S&P 500 – more cost efficient, the ETF turns 40 this year and there is cause for celebration of this revolutionary product.

ETFs have grown faster than any other financial product, total AuM surpassed that of hedge funds1last year and currently stands at over $3trn2. The industry is growing between 20-30% each year, with over 200 new funds created since August 20153. The reason behind this explosive growth is easily identifiable: ETFs are the best way to conveniently and efficiently diversify a portfolio. The stellar reputation currently enjoyed by ETFs is hardly surprising when you consider that last year only 16.1% of actively managed US equity funds outperformed the S&P 500. It’s hard to find investment articles that don’t suggest trying index Funds, but how? For the private investor choosing the right ETF isn’t easy, we’ve outlined four of the biggest hurdles below.

1. ETFs are bought, not sold

As a retail investor in the UK, ETFs are rarely promoted with anywhere near as much resources as more long-standing products such as actively managed mutual funds. This is entirely intuitive as, in general, ETFs seek to track different market indices as closely as possible and as cost efficiently as possible. As such, the same amount of resources does not go into their marketing. The result is that a lot of the time the end investor takes the perceived easier option and whether they invest through a DIY platform or a Financial Advisor will end up in actively managed funds.

2. The right ETF selection is complex

The ETF is, in theory, a simple financial product, (after all it ‘only’ replicates the Index). The technology behind it, however, as well as the selection criterion, are very complicated. In Europe, there are around 1,500 ETFs, which differ by nearly a dozen major and even more secondary factors. To name a few:

  • Cost : What is the cost in addition to the Total Expense Ratio (TER), the bid/offer spread, the total cost of ownership and so on. How are these costs to be evaluated? Finally to what extent will these charges be passed on to the investors?
  • Replication method : Is the ETF physically or synthetically replicated, and what does this mean for the security’s performance?
  • Tracking error : How exactly is the index replicated? Is there consistent tracking error due to changes in fees or tax treatment?
  • Liquidity : What is the volume traded and how easy is it to buy and sell when the market is moving quickly? Does the ETF price differ from the value of the underlying shares under certain circumstances? And how do such situations have to be dealt with?
  • Tax texture : What are the differences between an Irish domiciled ETF with automatic reinvestment and a Luxembourg-based fixed income tracker? Which issuing country can boast better treatment of foreign withholding taxes?

Traders and professional investors spend their days using the right tools, and with access to mountains of reliable data trying to answer the above questions. It simply isn’t possible for the individual investing in their spare time. Attempting to do so is almost guaranteed to result in a suboptimal choice, which, as we will see in the next section, can cost a lot of money over time.

3. Performance differences can be enormous

A recent German publication, Welt am Sonntag, compared the results between two ETF providers that covered the DAX over a 5 year period. Each year they noticed an average of 0.5% difference between their returns. This seems odd as both ETFs in theory did exactly the same thing; and while 0.5% doesn’t sound like much, when the effect is compounded over time the difference really adds up. Two £10,000 investments returning 5% and 5.5% over 5 years will return £12,762.82 and £13,069.60 respectively – the seemingly insignificant 0.5% has resulted in over £300 or 2.4% difference over a relatively short period of time.

4. Asset Allocation

Let’s assume that you have invested some serious time and effort in research of major stock market indices covering stocks, bonds, commodities and real estate and have the best ETFs identified. You are now faced with another decisive question: what is the weighting given to each asset class, and how long do you leave it before you re-weight – a year, 5 years? How likely are you to keep up to date with developments across each sector (bonds, stocks, commodities etc.) that might cause you to change your allocations? There isn’t an easy answer to these and many other similar questions for private investors. In short: the selection of ETFs is just the beginning, then the portfolio management really begins.

Conclusion

ETFs are great, but unfortunately for the majority of investors, due to the problems described above, they are difficult to use in an optimal portfolio design. Most investors have neither the time nor the resources to be an effective investment manager. Often, they choose between leaving the money sitting unproductively in a bank account, half-heartedly managing an ISA, or if they have enough capital, accepting expensive fees to have their money managed for them. These remarks should not be construed as scaremongering. Despite the difficulties, there is a solution: Scalable Capital. Our aim is to overcome these obstacles for private investors to create a cost-effective, optimal ETF portfolio that is continually monitored and adjusted automatically. Take a look at our
Webinar and find out more about what we do.

1 http://www.investmentweek.co.uk/investment-week/news/2418624/etf-assets-surpass-hedge-fund-aum-for-first-time-in-q2
2 http://www.investopedia.com/articles/etfs/071216/how-big-global-etf-market-blk-stt.asp
3 http://www.spcapitaliq.com/blog/are-there-too-many-etfs-to-choose-from

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Simon Miller
UK CEO & UK CO-FOUNDER
Formerly a derivatives trader at Barclays Capital, Simon merges capital markets knowledge and business development skills with an academic background in Economics, Business and Mathematics.