Not all Exchange Traded
Funds are created equal.
This holds true even for
ETFs that track the same
index. Differences come
in all shapes and sizes,
but the most important of them include cost, liquidity and the type of replication.
Sometimes those differences are small and insignificant.
Other times, they may appear to be small but can
become significant cumulatively and over the long run.
The ETF industry has ballooned, especially over the last couple of years, in large part due to the appalling failure of money managers’ attempt to shield their client assets from the ravages of the “great recession” of 2007. Public distrust and skepticism in the financial system grew further following AIG’s bailout, Lehman’s bankruptcy and Madoff’s elaborate ponzi scheme, prompting investors to flock into passive ETF investments. By the end of 2013, ETFs represented $2.4 trillion in assets in some 5000 funds compared to $700 billion in assets in 2007.
ETFs have evolved substantially from its beginnings, when the main purpose was to offer investors with affordable access to the performance of well established, transparent and broadly diversified indices. Today you have a wide array of ETFs to choose from, tracking all sorts of exotic instruments and even offering performance “aberrations” on a diverse range of indices. Navigating the broad and increasingly complex range of products in this space can prove challenging, even for the more seasoned of investors. This point is best illustrated with an example on sector investing.
Asset managers invest into sectors for all kinds of reasons, not least of which is an attempt to generate “alpha” through opportunistic tactical bets on specific segments of the economy. ETFs offer investors an extensive catalogue of sector investing opportunities.Suppose that you want to build a tactical exposure into a particular sector for your portfolio. You would normally proceed by selecting the ETF provider with the most competitive total expense ratio, highest trading volume and lowest overall tax impact. To be on the safe side, you might also take a look at what type of replication the ETF provider is using to track the index.
This basic due diligence process may well have been sufficient in the past. Today, however, a sector ETF has additional layers of complexities that warrant further investigation. You now have three categories of sector ETFs to choose from. The most common category is the standard or “plain vanilla” trackers, followed by so-called “intelligent” trackers that employ a screening process for the selection process of constituents. The third category is similar to the second with the added twist of being more concentrated on a particular subset of a sector.
Looking at the healthcare sector, the S&P Global 1200 Healthcare Index ETF is a good example of the “plain vanilla” type tracker, replicating a broad based and well established market capitalization index. In contrast, a tracker that screens the fundamentals of a stock instead of basing the selection on capitalization weights (as most ETFs tend to do) would fit into the second “intelligent” tracker based category. The First Trust Health Care AlphaDex ETF is an example of this.
In the third category that deals with sub sectors, the PowerShares Dynamic Biotechnology and Genome ETF is a good fit. Such trackers tend to exhibit a greater deal of volatility due to a higher degree of concentration and therefore require a greater degree of experience on behalf of the practitioner.
More granularity can be confusing, especially to the novice investor. For the seasoned practitioner, on the other hand, it offers more precision and control on tactical bets. As the ETF market continues to mature and competition heats up, new ETFs with even more subtle differences are likely to see the light of day, requiring additional skills with the selection process.
The ETF industry has ballooned, especially over the last couple of years, in large part due to the appalling failure of money managers’ attempt to shield their client assets from the ravages of the “great recession” of 2007. Public distrust and skepticism in the financial system grew further following AIG’s bailout, Lehman’s bankruptcy and Madoff’s elaborate ponzi scheme, prompting investors to flock into passive ETF investments. By the end of 2013, ETFs represented $2.4 trillion in assets in some 5000 funds compared to $700 billion in assets in 2007.
ETFs have evolved substantially from its beginnings, when the main purpose was to offer investors with affordable access to the performance of well established, transparent and broadly diversified indices. Today you have a wide array of ETFs to choose from, tracking all sorts of exotic instruments and even offering performance “aberrations” on a diverse range of indices. Navigating the broad and increasingly complex range of products in this space can prove challenging, even for the more seasoned of investors. This point is best illustrated with an example on sector investing.
Asset managers invest into sectors for all kinds of reasons, not least of which is an attempt to generate “alpha” through opportunistic tactical bets on specific segments of the economy. ETFs offer investors an extensive catalogue of sector investing opportunities.Suppose that you want to build a tactical exposure into a particular sector for your portfolio. You would normally proceed by selecting the ETF provider with the most competitive total expense ratio, highest trading volume and lowest overall tax impact. To be on the safe side, you might also take a look at what type of replication the ETF provider is using to track the index.
This basic due diligence process may well have been sufficient in the past. Today, however, a sector ETF has additional layers of complexities that warrant further investigation. You now have three categories of sector ETFs to choose from. The most common category is the standard or “plain vanilla” trackers, followed by so-called “intelligent” trackers that employ a screening process for the selection process of constituents. The third category is similar to the second with the added twist of being more concentrated on a particular subset of a sector.
Looking at the healthcare sector, the S&P Global 1200 Healthcare Index ETF is a good example of the “plain vanilla” type tracker, replicating a broad based and well established market capitalization index. In contrast, a tracker that screens the fundamentals of a stock instead of basing the selection on capitalization weights (as most ETFs tend to do) would fit into the second “intelligent” tracker based category. The First Trust Health Care AlphaDex ETF is an example of this.
In the third category that deals with sub sectors, the PowerShares Dynamic Biotechnology and Genome ETF is a good fit. Such trackers tend to exhibit a greater deal of volatility due to a higher degree of concentration and therefore require a greater degree of experience on behalf of the practitioner.
More granularity can be confusing, especially to the novice investor. For the seasoned practitioner, on the other hand, it offers more precision and control on tactical bets. As the ETF market continues to mature and competition heats up, new ETFs with even more subtle differences are likely to see the light of day, requiring additional skills with the selection process.
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