How Advisors Can Improve ETF Due Diligence

As of the end of 2022, there were 8,754 exchange traded funds listed around the world with nearly $10 trillion in combined assets under management. That’s staggering population growth when considering two decades prior, the number of ETFs trading around the globe was just 276.

Of note to advisors, as of the end of February 2023, the U.S. is home to 2,956 ETFs with a combined $6.628 trillion in assets. All of that is to say that advisors face a dizzying array of choices in the world of ETFs even when accounting for a selection universe that’s well below 2,956 due to various limitations and requirements imposed by clearing houses and custodians.

Say an advisor’s custodian only allows for access to 1,000 ETFs, that’s still a mammoth number and one that makes due diligence daunting. Obviously, advisors are aware of this mountain, but they and their clients love ETFs. Flows to the products confirm as much.

As a result, some advisors are prone to engage half-measure due diligence when it comes to ETFs, including merely focusing on brands and fees. Smart advisors know there’s more to this particular ballgame and putting forth a little extra effort can bear fruit in terms better outcomes for clients. Here are some tips for elevating ETF due diligence.

Methodology, Structure Matter

With any ETF – active or passive – advisors should take the time to understand structural issues, including investment objective, tax treatment and custodian matters, among others. Fortunately, none of those are difficult pursuits.

Here’s where things get interesting. Due diligence is arguably more meaningful with passive ETFs than active counterparts because the former are, obviously , linked to indexes. There are far more indexes in the world than there are passive funds, which is to say few index are mirror images of each other. Indeed, this creates due diligence demands.

“Advisors should make sure their understanding is clear. The index must be measurable, appropriate and reflective of current investment options,” notes FlexShares. “For equities, determine if it has the desired capitalization weighting, return variance, style, country, sector or manager risk. For fixed income, establish whether the strategy delivers the desired asset class exposure, risk and yield. Advisors should also evaluate the potential challenges and the benefits of beta, alternative-weighted or actively managed indexes.”

Next up, myth busting should be part of the ETF due diligence process. That includes debunking the notions that the “best” funds hail from the biggest issuers, are themselves large as measured by assets under management and have low fees.

In the U.S., the ETF industry is roughly three decades old and over that time, no research has emerged there are correlations between branding, AUM and investor outcomes.

On the other hand, there is data suggesting that lower fees are impactful over the long-term. However, fees aren’t the end all and be all of ETF investing. Consider the following hypothetical example. Suppose an advisor allocates client funds to a large-cap growth fund with an annual fee of 0.05%, or $5 on a $10,000 stake. That fund returns 30% over three years. Another advisor directs client capital to a comparable product with a 0.45% expense ratio, but that product returns 50% over three years. That rendered the former ETF’s fee advantage moot.

Speaking of Fees…

An ETF’s expense ratio is what the issuer advertises, but what’s often overlooked is the fund’s total cost of ownership. That’s comprised of the expense ratio, spreads and tracking error. In other words, a “cheap” ETF with large spreads and substantial tracking error may not be so cheap after all.

Next, an advisor should consider other costs of the explicit, implicit and opportunity varieties. Explicit costs are those addressed in the total cost of ownership whereas implicit costs are different beasts.

“Unlike explicit costs that can be researched across many data sources, implicit costs can be harder to quantify. While they may require more effort to unearth, implicit costs are just as important as their explicit counterparts. Implicit costs include capital gains, turnover within the fund, the funds tracking success against its index (or a standard market benchmark) and distribution or platform fees,” adds FlexShares.

The point: If an advisor makes an itemized list of the points mentioned here, the homework appears daunting. It’s not, but it is worth it because clients will be the ultimate winners.

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