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The Top Factors to Consider When Selecting an ETF

Total expense ratio (TER) is the most critical factor to consider when selecting an ETF, according to a survey presented by the EDHEC-Risk Institute

Hortense Bioy, CFA 18 April, 2013 | 3:05PM

The Total Expense Ratio (TER) has increased in importance when selecting an ETF, according to a survey presented by the EDHEC-Risk Institute at its annual European conference on March 26.

Total Expense Ratio

For more than two thirds of survey respondents (68% in 2012, compared to 61% in 2011), TER was the most critical selection criteria. This result shows that investors are scrutinising ETF costs more closely, even though they are already a comparatively low cost vehicle.

This result also supports recent decisions by some ETF providers to cut fees. While intensifying price competition is today more evident in the US, the entrance of low cost providers like Vanguard in Europe is starting to put pressure on well-established players. 

Underlying Index

The underlying index was cited as the second most important ETF selection criteria. This makes perfect sense, as the reason for investing is to gain a specific type of exposure and for an ETF this will be determined by the index it tracks.

Looking under the bonnet of an ETF to examine the underlying index composition and its potential sector and/or stock biases is key to understanding the fundamental drivers of the fund’s performance. Other index features like weighting methodologies, re-balancing frequency and dividend treatment may also affect the performance of an ETF. 

Bid-Offer Spreads

Bid-offer spreads received the third highest score of importance among the criteria used when selecting an ETF. Again, in the context of ever-shorter holding periods, this result doesn’t come as a surprise. Bid-offer spreads are a cost associated with buying and selling an ETF on the secondary market. The tighter the spreads, the lower the total cost of owning the ETF for the investor.

When it comes to ETF liquidity, bid-offer spreads are the most commonly used measure, but by no means the only one. Other measures often used as proxies for ETF liquidity include turnover and assets under management, both of which may arguably give a better indication of the depth of liquidity.

Tracking Error

Another essential selection criterion considered by survey respondents was tracking error. ETFs are designed to track the performance of an index, and tracking error assesses how well they do that job. The lower a fund’s tracking error, the more consistently it will track its benchmark. 

When evaluating the tracking quality of an ETF, tracking error is not the only metric investors should look at. One limitation of tracking error is that it doesn’t capture the actual magnitude of underperformance or outperformance of an ETF. In order to gauge this, investors should also look at tracking difference.

Counterparty Risk

Another key selection criterion highlighted by the EDHEC-Risk survey was counterparty risk. The issue of counterparty risk in ETFs has been extensively discussed over the past couple of years within the context of the physical vs. synthetic replication debate. It is now widely accepted that both replication methods may potentially present counterparty risk (e.g. from swaps in synthetic ETFs and from securities lending in certain physical ETFs). While a majority of investors have a clear preference for physical replication, they also acknowledge the merits of synthetic replication, namely, lower tracking error and access to inefficient and illiquid markets.

Tax Regime

Other ETF selection criteria highlighted by the EDHEC-Risk survey included: house reputation, UCITS compliancy, assets under management, ETF domicile, tax regime, dividend policy. It is worth stressing the importance for investors to closely examine the tax regime of an ETF as it may affect the total return of their investments. UK investors in particular should ensure that the fund has UK ‘reporting’ or ‘distributor’ status with the UK tax authorities, as they may otherwise see any realised gains taxed at income tax rates of up to 50%, rather than the lower capital gains rates of either 18% or 28%.

(Click table to enlarge)

The EDHEC-Risk survey asked ETF-related questions to 212 European investors ranging from institutional investment managers to private wealth managers.

 To read the complete survey, click here.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  is director of passive funds and sustainability research in Europe for Morningstar

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