ETF DUE DILIGENCE

HOW TO CHOOSE THE RIGHT ETF

A five-step due diligence guide to evaluating ETFs for your portfolio

WHICH ETF SHOULD I BUY?

With over 14,600 Exchange Traded Funds (ETFs) available globally1, the astute investor needs to conduct robust due diligence to understand the ETF they are investing in. Investors can (and should) focus on a variety of factors when selecting ETFs to help them achieve their desired investment objectives.

Selecting an ETF may be an overwhelming process. We believe it all starts with asking these five questions:

  1. Exposure: What is the ETF’s investment objective?
  2. Structure: What are the implications of the ETF’s structure?
  3. Performance: How should you evaluate the performance of an ETF?
  4. Domicile & taxes: How does the fund’s domicile affect the investor?
  5. Liquidity: What are the multiple layers of liquidity inherent to the ETF structure and how do you evaluate it?

STEP 1: INVESTMENT OBJECTIVE & EXPOSURE

Index ETFs are designed to track indices, so understanding the index that the chosen ETF tracks is important. ETFs come in many flavors and an ETF’s performance follows an index or sector closely, like the Straits Times Index (STI) or S&P500. Also, different indices select their holdings using different rules.

Since indices can differ significantly in terms of investment type and strategy, understanding the index construction methodology is key in helping investors differentiate among many indices in the marketplace.

Caption:

Index construction methodologies and some examples of key asset class indices. The examples provided here are for illustrative purposes only.

  • Country (e.g., STI)
  • Region (e.g., MSCI Europe)
  • Sectors (e.g., Hang Seng Tech)
  • Size (e.g., FTSE China A50, MSCI USA Small Cap Index)
  • Style (e.g., S&P500 Value)
  • Liquidity
Apply weighting
  • Market capitalization
  • Equal weighted
  • Capped
  • Fundamental
  • Risk
Further definition
  • Currency hedged
  • Price/ total/ net returns
  • Leverage
Custom index
Caption:

Index construction methodologies and some examples of key asset class indices. The examples provided here are for illustrative purposes only.

Select universeApply weightingFurther definitionCustom index
  • Country (e.g., STI)
  • Region (e.g., MSCI Europe)
  • Sectors (e.g., Hang Seng Tech)
  • Size (e.g., FTSE China A50, MSCI USA Small Cap Index)
  • Style (e.g., S&P500 Value)
  • Liquidity
  • Market capitalization
  • Equal weighted
  • Capped
  • Fundamental
  • Risk
  • Currency hedged
  • Price/ total/ net returns
  • Leverage

STEP 2: ETF STRUCTURE

There are different ways of structuring an index ETF to achieve the investment objective of the fund. The two most common structures for index ETFs are:

  1. Physical replication: Gain exposure to the performance of the underlying index by holding all (full-replication) or a portion (typically achieved through optimized or stratified replication) of the underlying assets.
  2. Synthetic replication: Gain exposure to the performance of the underlying index through swap agreements.

Why should I care about an ETF’s structure? As part of the ETF selection process, it is important to understand the differences in ETF structures – physical and synthetic - as replication mechanisms can impact cost, performance, and risk profiles.

STEP 3: IMPLICATIONS OF DOMICILE & TAXES

Taxation of ETF investments may arise at three levels:

  1. Investment level: The type of investment (such as equity or fixed income investments) and the country in which the investment is domiciled will have an impact on whether the ETF is subject to local taxes on income or capital gains.
  2. ETF level: There may be a direct tax on the income earned by the ETF in its country of domicile.
  3. Investor level: Shareholders may be subject to taxation on income and capital gains. Investor taxation depends on the investor’s personal circumstances in their home jurisdiction.

Withholding tax mainly arises in the country where the underlying equity or fixed income investments are domiciled. The tax rate partly depends on the treaty between the country where the underlying securities are domiciled and the country in which the ETF is domiciled. There can be a withholding tax at two (out of three) levels of taxation described above:

  1. Investment level: When the ETF receives income or gains from the underlying investments, there can be local withholding taxes in the jurisdiction in which the underlying investment is situated.
  2. ETF level: When the ETF makes a distribution to the investor, there can be a withholding tax in the ETF’s country of domicile.
  • Exempt: Investors who qualify for 0% US withholding tax, such as sovereign wealth funds and pension funds in some countries.
  • Treaty: Investors who qualify for the treaty rate (15%) US withholding tax – onshore taxpaying investors in many European and Asian countries who have provided W-8BEN documentation.
  • Non-treaty: Investors who pay the full 30% US withholding tax rate, including offshore investors, onshore investors from non-treaty countries, and investors not providing W-8BEN.
Withholding tax for US equities

If we assume that the US equities held by the ETF generate a $100 dividend distribution, taking into account withholding tax, the final dividend would be:

Withholding tax for US equities
Withholding tax for US bonds

If we assume that the US bond held by the ETF generates a $100 coupon, taking into account withholding tax, the final coupon would be:

Withholding tax for US bonds

STEP 4: EVALUATE PERFORMANCE

Performance doesn’t just mean how much money you make or lose as the ETF’s underlying index rises and falls. It is also about how closely the ETF matches the index performance.

Most index ETFs are managed to track the investment results of an index. ETFs that fail to closely track their respective indices often reflect the difficulties of investing in the market, such as the unavailability of certain securities or regulatory restrictions, including some that may be expensive or impossible to buy or sell. ETFs that do not fully replicate an index’s securities hold a subset of securities designed to closely track the index.

A well-managed ETF minimizes both tracking error and tracking difference to deliver accurate index performance:

Tracking difference is the return difference between the ETF and its underlying index over a given period. It addresses how well the fund tracks the index returns.

Tracking Difference

Tracking error is the volatility (as measured by standard deviation) of the tracking difference. It reflects how consistent the tracking quality is. Investors benefit from a lower tracking error because it means the tracking difference is more predictable.

Tracking error can be caused by a wide range of factors:

  • difference between the holdings in the fund and those in the index
  • rebalancing and transaction costs
  • different tax treatments of underlying income in the fund and those in the index
  • fund replication method
Tracking Errors

STEP 5: EVALUATE TRADING & LIQUIDITY

ETFs are easily tradable, even in times of market stress. Their exchange tradability improves liquidity, enabling investors to buy or sell ETF shares (or units) without triggering a trade in the underlying markets.

The liquidity of an ETF is not limited to its on-screen liquidity (which is indicated through ETFs bid/ask prices and average daily trading volume). Instead, we can think of ETF liquidity as an iceberg, with multiple layers of liquidity below the surface that are not always visible at first glance.

ETF primary and secondary market liquidity

A lot of trading occurs in the secondary market, no different than a stock. Investors buy and sell ETFs in the market using common order types and ETFs are quoted with bid-ask prices. However, secondary market liquidity is only the tip of the iceberg.

For example, if there are not enough ETF shares in the secondary market which typically may be referred to as 'ETF inventory', Authorized Participants4 can access the underlying market liquidity by purchasing the underlying securities and exchanging this for ETF shares in a process known as creation. These units can then be sold again in the secondary market.

Overall, ETF liquidity is driven by multiple different components, with a large majority deriving from the liquidity of the ETF's underlying securities.

While each trade requires individual consideration, here are some best practices to consider when trading ETFs:

  • Knowledge of the underlying: ETFs offer exposure to multiple asset classes and regions but one should be mindful of the underlying’s market hours, holiday closures, and trading dynamics.
  • Time of day: Markets can be more volatile towards the market open and market close. Consider underlying market hours as this could impact the pricing and liquidity of the ETF.
  • Order type: If you are trading on-exchange, you should ensure your order type is consistent with your goals. To help protect against price swings, consider using limit orders (especially in volatile markets).

ETF DUE DILIGENCE FAQs

If an investor intends to hold an ETF for a longer period, it is more appropriate to use tracking difference over a longer horizon to assess ETF performance. Both are important because the ETF manager’s ultimate goal is to consistently track the underlying index.

  • Tracking difference addresses how well the fund tracks the index returns. It is the simpler measure to understand, and likely the most relevant. For long-term investors, tracking difference is more important.
  • Tracking error reflects the consistency of the tracking quality. Investors benefit from a lower tracking error because it means that the tracking difference is more predictable. For short-term investors, tracking error is more important.

ETF prices are usually a precise reflection of fair value (the sum of the underlying securities). But there is often a slight discrepancy between the price and the book value of an ETF. Some reasons for this discrepancy:

  • Time factor. Occurs when the ETF holds securities not traded at the same time as the ETF itself. For example, US equities can be traded with ETFs even when the US market is closed.
  • Bond ETFs. The portfolio of a bond ETF is usually valued at the bid price (i.e., the net asset value is calculated from the bid prices of the individual bonds). When buying the ETF, the entire bid/offer spread arises and the ETF trades with a natural premium; when selling the ETF, usually only minimal costs (for administration, etc.) arise since the bid/offer spread has already been paid when buying.
  • Supply and demand. Sometimes, supply is greater than demand and vice versa, leading to a premium or a discount. This is usually only a temporary phenomenon. In periods of market volatility, the differences between prices may become greater until prices find a new equilibrium.

ETFs attempt to replicate an index like the S&P 500 or MSCI World. When buying an ETF, you therefore invest in each individual company contained in the relevant index. Even though ETFs are traded like equities, you can also invest in ETFs that replicate bond, commodity, and real estate indices. All the major asset classes are covered by the ETFs and are also available for country-specific, regional, and global investment. They cover almost all sectors, including technology, telecommunications, renewable energy sources, and consumer goods. It is also possible to invest in government, corporate, or emerging market bonds via ETFs. Learn about the different types of ETFs.

Investors should be aware that, like any other form of investment, ETFs are not guaranteed products and are subject to risk of loss. Since there are many different types of ETFs, some funds are riskier than others. When investing in an ETF with securities not listed in the investor’s base currency, fund returns may be affected by exchange rate fluctuations. Many ETFs therefore also hedge currencies to reduce this risk. There is the risk that fund returns may deviate from the return determined for the index on account of costs, cash holdings, additional returns, or other factors. Learn more about ETF risks.

KEY TAKEAWAYS

To recap, ask the following questions the next time you select an ETF:

  1. Exposure: What is the ETF’s investment objective?
  2. Structure: What are the implications of the ETF’s structure?
  3. Performance: How should you evaluate the performance of an ETF?
  4. Domicile & taxes: How does the fund’s domicile affect the investor?
  5. Liquidity: What are the multiple layers of liquidity inherent to the ETF structure and how do you evaluate it?