ETFs: how to sort the wheat from the chaff

INNOVATION is not always a good thing, or at least, that is what David Norman of TCF Investment says about the boom in exchange traded funds (ETFs): “There’s been a big rush to launch products: a lot of innovation, not all of it is good. Say you want exposure to a certain emerging market, for example, which of the 25-odd indices do you track?”

The ETF providers do not agree. Manooj Mistry from db x-trackers says: “There aren’t too many products. People should compare the ETF market to the fund market. There may be 25-odd ETFs giving you exposure to the Chinese market, but there will be hundreds of funds in that area. With due diligence and adequate research the choice is comparatively simpler.”

So what due diligence and research should a potential ETF investor do? Can probing below the surface of similar products help investors decide where to invest?

A good place to start is working out exactly what the fund is investing in. This may sound obvious to those who know which market they wish to target, but it is important to bear in mind that not all indexes are the same. In fact, even the same index can be skewed by ETFs that favour certain sectors. Allianz’s latest Brazil Fund for example has deliberately targeted industries, which are exposed to the growth in middle class consumer goods. To make the most from these differences you need to be clear about which sectors you want to target.

There is no disadvantage to selecting a well-known index. In fact, iShares actively encourage it. A widely accepted index is a good benchmark for those bedazzled by the choice. But it is still worth checking to which sectors you are getting exposure. The Brazil MCSI Index for example is heavily skewed towards the energy industry. Vale and Petrobras make up 50 per cent of the index. Investors need to be confident of their research into the productive sectors of any economy even if they rely on a well-known index to invest.

Cost is another obvious consideration. Investors should be careful not to be fooled into thinking that the total expense ratio (TER) is an accurate reflection of the whole cost of an ETF. There are brokerage costs to consider since ETFs are bought and sold like ordinary stocks. But there are also trading costs reflected in the bid and ask price and rebalancing costs from the index providers such as the FTSE, S&P and Dow Jones. These vary depending on the structure of the index.

Certain ETFs can actually generate additional revenue that can offset these costs. Securities lending is a good example of this. Dividend enhancement and good management of an index can also improve returns. This means that an ETF with a TER of 0.25 per cent with low trading costs and a low rebalancing cost, for example, could generate 0.20 per cent of additional revenue and work out the same price as an ETF with 0.15 TER and lower revenue.

These costs considered together can make a significant difference to the package that an investor buys into. Investors should systematically work through them when faced with a number of similar products.