What makes the best ETF?

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What makes the best exchange-traded fund? It depends. Yes, it’s that age-old answer to many questions in the world of finance and investment. The best ETF really depends on what you want from the ETF. 

Easily measurable metrics, such as assets under management and the age of the ETF, can be a helpful guide, especially for popularity and even success. But what makes the best ETF for one investor will be very different for another. 

To make that judgement, you need to begin with a clear understanding of your investment objective, the time horizon and attitude to risk. While this is vastly different among investors, one crucial factor common to all investors is costs. Keeping costs low means that you keep more of your returns, which will improve you and your organisation’s chance of investment success. 

The next consideration is the asset class in which you want to invest. Almost 1,600 ETFs are available in Europe¹ and the overwhelming majority track an index. They range from familiar asset classes like traditional government bonds and large-cap US equities to niche areas for specialists such as commodities, real estate and other specific sectors and sub-asset classes. With so much choice, you won’t struggle to find an ETF that covers the desired asset class.  

Transparency

To judge whether the ETF is the best suited to your needs, it needs to be transparent. You need to be able to assess whether the index accurately reflects the market or asset class in which you want to invest. 

Under UCITS regulations, the indices tracked by ETFs must be freely available, but that is not the same as saying the index methodology is clear, easy to find and easy to understand. For example, an index of large-cap Spanish shares may be published daily and use standard methodology, but if it is only published in Spanish that will be a problem for non-Spanish-speaking investors. 

Indices should use straightforward construction techniques. For instance, they should only include securities available on the open market; any market-capitalisation divisions should overlap to help manage turnover; any factor or style analysis should not rely on a single metric; and rebalancing should reflect market changes in an orderly fashion. 

These principles underlie smart index construction. As a result the portfolio should have lower turnover and transaction costs. Ideally, it will also help investors implement their asset allocation strategies more efficiently, with limited overlap among the different sleeves of their overall portfolio. 

Portfolio construction 

Along with a transparent index, the ETF’s portfolio also needs to be transparent. How does the ETF invest its assets? Index-tracking ETFs can do this in two ways, either physically or synthetically. 

Physical ETFs hold all, or a representative sample, of the underlying securities that make up the index. For example, an S&P 500 ETF invests in each of the 500 securities represented in the S&P 500 index, or some subset of them. Physical replication is reasonably straightforward to understand. This may explain physical ETFs’ increasing popularity. 

Synthetic ETFs track their chosen index by using derivatives contracts, such as swaps.  These contracts are agreements between the ETF and a counterparty – usually an investment bank – to pay the ETF the return of its index. In essence, the synthetic ETF tracks its index without actually owning any of its securities. The agreements also involve collateral, margin calls and exposure to counterparty risk. These additional requirements and additional sources of risk may also partly explain while physical ETFs have become more popular. 

While there is a clear preference nowadays for physically replicated ETFs, synthetics have their place, especially among institutional investment portfolios. They often give exposure to assets that are difficult or impossible to own physically, such as commodities or currencies. 

The best ETFs in terms of portfolio construction are the ones that are upfront about how they invest the assets and explain their methodologies. 

UCITS regulations

The UCITS framework governs most European-domiciled ETFs. It demands investor protections such as diversification and the ring-fencing of assets with a custodian. 

This second point is another significant difference between physical and synthetic ETFs. The assets of physical ETFs are held by a custodian. Investors have direct legal entitlement to those securities. The investment manager cannot lay claim to them should they need to if, say, they ran into financial difficulties. 

While synthetic ETFs operate under UCITS, they hold contracts rather than physical assets, which exposes investors to different kinds of risks, such as collateral and counterparty. 

The product’s track record

Looking at track records can also guide investors as to whether a particular ETF is the best for them. There are three aspects to this. The first is the product’s track record. To evaluate this, excess return (sometimes called tracking difference) and tracking error are the most important metrics.

Excess return measures an ETF’s performance against its benchmark index over a specific period of time by simply subtracting the index’s total return from the ETF’s total return. Typically, it is negative because an ETF’s performance includes its expenses. But there are a number of factors that can affect excess return either positively or negatively, such as the sampling or optimisation method, fair-value pricing and cash drag. The manager’s skill and experience can also make a difference, particularly when adding new index constituents to the portfolio or managing dividend re-investment. 

Positive excess return, however, is not an indication of the best ETF. While it may be welcome, investors most often want their ETF to match the risk profile of their chosen asset class. The tracking error provides insight into this aspect. 

Using tracking error as a metric requires some caution because different ETF providers define it in different ways. Some simply refer to it as the difference between an ETF’s return and the return of its benchmark index, which is really excess return. However, the formal definition of tracking error is the annualised standard deviation of excess return. In other words, while excess return measures the amount by which an ETF’s return differs from that of its benchmark over a specified period, tracking error measures how much variability exists in the ETF’s excess return.

When assessing the best ETF, bring it back to your investment objective and time horizon. Investors seeking total return over a long-term time horizon should use excess return as a more important measure than tracking error. However, over the short term, investors who care more about performance consistency and want to minimise volatility should focus on tracking error. 

The index’s track record

The second aspect of track record is that of the index. Well-established indices should give investors the exposure they seek. Constructed with sound methodology, they are a true reflection of the market or sector. 

These indices have stood the test of time, showing consistency not just in construction but also exposure over time. This should help investors avoid fads touted as the next big thing, which may ultimately not deliver the expected returns. 

The main message is don’t buy on performance alone. Understand what you’re buying and why. If you’re swayed by strong performance and asset gathering, short-term decisions could have lasting undesirable effects on your portfolio.  

The ETF provider’s track record

The final aspect is the provider. The best ETF providers will be investing in time, talent and technology to make sure their products are the best for investors. 

This will be evident in the strength of relationships that the provider has within the ETF ecosystem. They will have multiple authorised participants and market makers for their ETFs along with an experienced, helpful and approachable capital markets team for placing large trades more efficiently and effectively. They will be able to explain and educate not just on how to trade but also on the different roles ETFs can play in a portfolio. 

ETF investment managers with a long history of managing a diverse range of index-tracking products will have large teams of experienced, dedicated personnel, from fund managers and traders to fund accounting and corporate actions teams. As I mentioned earlier, this experience and skill can make a difference in returns. 

Low cost

A final consideration for the best ETF is cost. Again, transparency is key. There should be no hidden charges or fees. Established providers should have the scale to keep costs low. And large ETFs with significant assets under management should also have the scale to reduce costs. After all, as I said at the beginning, the lower the cost, the more of the return an investor keeps.  

Mark Fitzgerald is responsible for Vanguard’s equity product management in Europe