28 April 2021 / Growth of ETF

Know Your ETFs: The Art of Selection

Investors expect ETFs to be easy, straightforward, transparent and liquid. These expectations tend to underestimate their actual risks and the need to carry out a thorough due diligence process in the same way as for active or alternative strategies. This misconception is itself set against a background of a profusion of options facing investors when choosing the right ETF to implement any given index strategy.

The emergence of active and smart beta index strategies, particularly thematic indexes, emphasizes the need for a robust and in-depth selection process to identify best-in-class asset managers and ETFs. Moreover, owing to the fast-paced growth of the ETF ecosystem, today’s best choice might no longer rank first tomorrow. Finally, for regulatory and fiscal reasons, the choice of an ETF will rarely be unanimous. Therefore, using the right set of criteria with a dynamic selection process that is capable of adapting to innovation is key.

Measurable vs unmeasurable criteria

ETFs have proven to be a real ally for investors during 2020 in terms of liquidity and diversity. The flip side to the phenomenal growth of ETFs is that investors can easily feel confused by the wide range of options that are not necessarily equal in quality.

Today’s investors are indeed overwhelmed by the large number of potential candidates when choosing ETFs to implement their market views. To illustrate the fragmentation of the industry, it is worth mentioning that over 70 ETPs track the gold spot, and over 100 replicate the S&P 500 and the MSCI World indexes respectively, among 6,600+ ETPs available across the globe.

To separate candidates across the ever-growing ETF ecosystem, investors tend to focus on the same measurable criteria such as the ETF size, track record length, ongoing charges (TER), tracking difference and error to assess the replication quality – as well as liquidity. Some of them will stay away from synthetic replication by default due to the misconception of the counterparty risk carried by a derivative contract in the background.

The annual survey conducted by Trackinsight revealed that liquidity is, and so far remains, the most important criterion for professional investors as shown in Figure 3.1. It is interesting to note that statistics favour measurable criteria and allocate a reduced portion to qualitative criteria as one would do for active and alternative managers.

Choosing the right ETFs - Importance of ETF selection criteria. Source: TrackInsight, IHS Markit. Retrieved from 2021 Global ETF Survey.

As a result, these straightforward and mostly measurable criteria do not consider some risks and structural efficiencies which could make the difference in terms of portfolio construction and fully leverage on the innovation power of some ETF providers.

The challenge is even more difficult as there are no market standards in terms of need and methodology when dealing with ETF selection and manager due diligence.

Look behind the scenes

Counterparty risks are often either undefined or overlooked, namely the ETF provider as an asset manager, securities lending or swap activity as well as collateralization percentage and quality at the ETF level. Cost efficiency should rely on the estimation of the ETF’s total cost of ownership, of which the TER is only one component. There are several cost layers which are often ignored such as swap fees and stamp duties to name but a few.

Issuers may structure an ETF in a way that delivers an optimal tax efficiency achieved by leveraging the vehicle structuring such as the replication approach, the income treatment, the fund domicile and tax statuses.

These features are key selection criteria but again not always equal in quality and coverage among ETFs. Moreover, depending on the fiscal profile, the best choice might not be the same from one investor to the other. This deep-dive exploration also helps determine the degree of transparency ETF providers will commit to and the information reliability, both factors being very heterogenous across the industry. Indeed, data collection in terms of quality and accessibility can make a huge difference when putting in place manager due diligence and ETF selection processes.

Some additional selection criteria should be exposure or asset class specific. For thematic or ESG ETFs, the ETF provider’s expertise on the investment theme as well as its ESG engagement and stewardship should be challenged respectively to come up with a consistent top-down selection process. The case study of gold ETPs which seem straightforward as the index is simply the gold spot, fully illustrates the need to go beyond standard metrics.

Gold ETPs shone brightly in Coronavirus crisis, but differently

Gold has risen as an inescapable shield in 2020 as the precious metal is usually seen as the safe-haven asset in periods of economic uncertainties, distress, and a hedge against inflation. As a result, 2020 has put Gold ETPs in the spotlight as an obvious cost-efficient implementation solution pushing ETF providers to come up with differentiating and innovative features.

According to the World Gold Council, physical-backed gold trackers – which were first launched in Europe by ETF Securities in 2004 and acquired by WisdomTree – account for around one third of investment gold demand.

Choosing the right ETFs - Gold ETPs, Cumulative Flow in $bn. Source: TrackInsight, IHS Markit. Retrieved from 2021 Global ETF Survey.

ETPs backed by physical Responsible Gold bullions have emerged as a differentiating feature among ETF providers. The definition relies on the Responsible Sourcing Gold Guidance of the London Bullion Market Association (LBMA), which protects the integrity of the global supply chain for the wholesale precious metals markets including measures to combat money laundering, terrorist financing and human rights abuses globally.

Since 2012 the LBMA has required Good Delivery refiners to meet these standards which undergo continuous improvement. Therefore, selecting gold trackers which optimize exposure to post-2012 gold bullions complies with an enhanced ethical footprint. ETPs backed by responsible physical gold bars have therefore found their way into some ESG mandates keen to include gold in their asset allocation. It should be noted that this distinctive feature is mainly found among trackers domiciled in Europe.

Moreover, gold ETPs have passed the liquidity test during the unprecedented dislocation of the underlying market due to lockdown measures imposed in March 2020, which significantly altered the transportation of physical gold.

The disruption between the price of gold futures and physical gold had a clear impact on ETP bid-ask spreads but again in a very heterogenous way across products. The primary market impact of creating and redeeming units should be comparable as all physical gold ETPs have the same access to the underlying gold market. However, the story can be quite different when looking at the liquidity of the secondary market. The higher the number of liquidity makers (i.e. market makers, authorized participants) covering an ETP, the more competitive its pricing, hence reducing liquidity risk especially during periods of market stress.

Figure 3.3 shows the huge discrepancies among average bid-ask spreads for European physical gold ETPs in 2020.

Choosing the right ETFs -Gold ETPs Spreads, bps. Source: TrackInsight, IHS Markit. Retrieved from 2021 Global ETF Survey.

To sum up, in the case of Gold ETPs, a thorough due diligence process should include a full picture of the product: collateralization by allocated, identified bullions of superior quality in terms of purity and traceability, deposited with and kept in custody, along with replication and cost efficiency. Fast-paced growth underlines the need for robust ETF selection.

A fast-growing ETF industry reinvents itself constantly to response to intense competitiveness. As a result, ETF providers try to differentiate themselves by coming up with innovative and distinctive features which can be missed without a thorough due diligence process. The case study of gold trackers perfectly illustrates that having a look at what happens behind the scenes can make a huge difference in terms of ethical investment and liquidity risk mitigation.

Selection criteria must match investors’ investment and tax constraints as well as their risk and cost appetite, but they might also need to be asset class or exposure specific. To capture new ideas and stimulate innovation, an ETF selection process should look beyond standard metrics and dig into investment, counterparty, survivorship, and liquidity risks along with tax and cost efficiencies simultaneously. The danger is to not fully know your ETF, or even worse to mistakenly believe you do know it because at the end of the day, the greatest risk is the unknown.

To read more, download the full 2021 Global ETF Survey here.



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