Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 178

Improving ETF selection based on principles and data

Exchange Traded Funds (ETFs) increasingly come in different shapes and sizes and offer efficient access to more asset classes and sectors than ever before. Growth has been rapid. Of the 150 Exchange Traded Products on the ASX, 80 have been listed since 1 January 2013. This is good news, because they usually bring access at a reduced cost compared to other investment vehicles. ETFs now play an important role in investment portfolios, confirmed by the increase in usage and popularity.

Investors need to understand ETF transparency better

As a research house, we contend that ETF selection processes and criteria need to move to another level beyond the current simplistic approach. Factors like funds under management (FUM), age of fund, performance (relative or otherwise), tracking error, issuer confidence, fees, ease of compliance, platform access et al are all, in our view, only the basics.

More work needs to be done to fully understand ETFs and the differences between them. A focus on only the basics misses too much critical information.

Fortunately, the transparency of underlying assets in ETFs allows a much deeper analysis, such as the sector and geographic allocations of each fund. Additionally, by applying the traditional tools of security analysis to each underlying constituent, we can develop a view of a fund’s investment potential based on fundamentals such as earnings growth and valuation multiples. This is a forward-looking approach.

ETF selection should be about building the appropriate research-based ‘investment case’ that matches an investment criteria. Our approach facilitates this for example by distinguishing which funds are most appropriate for a ‘growth at a reasonable price’-type investor versus which funds are better suited to an income-oriented investor.

As an example, a ‘plain vanilla’ equity ETF is simply a basket of equities that seeks to track a given index. We can calculate a detailed series of equities-specific data points (e.g., earnings growth, valuation multiples) as well as the investment exposure the fund holder receives. From there, we can begin to compare ETFs from within their peer groups and even across peer groups.

Under the hood: investing in Europe via ETFs

For example, within the ‘Europe’ peer group, Australian investors can access five equity-based options, one of which is hedged back to the Australian dollar. These come from five different issuers and track five different indices, as shown in Table 1.

Table1: Peer group of European ETFs in Australia

From this data, observations may conclude that older funds may generally have large and sticky Funds Under Management though they may be relatively expensive. Fees can range greatly, with younger funds generally being cheaper. There’s also a premium to pay for hedging and the stock count within each fund varies widely.

When we check the underlying assets, we find all five funds have at least some exposure to each of the ten major sectors, and each is reasonably well diversified, which is not always the case with ETFs. Still, there is plenty of variation, with HEUR offering little exposure to Energy at just 1.4% versus 7.4% for ESTX. For Consumer Discretionary they flip places, with HEUR at 18.3% of assets compared with 10.5% for ESTX.

Among country exposures the differences can be significant (Table 2). For example, while IEU and VEQ put about one-quarter of assets in Great Britain, ESTX and HEUR have none. Depending on how Brexit proceeds, that’s likely to have a big difference in returns!

Table 2: Major country exposures of European ETFs

We begin to see that the different rules of each index result in difference exposures. To quantify exactly how similar (or dissimilar) one fund is from another, we introduce Overlap Analysis, which measures the extent to which the positions in each ETF are identical.

Table 3: Overlap analysis of European ETFs

With ESTX as a reference, the overlap with HEUR is 48.3%, meaning nearly half of the fund’s positions are identical. This is important because differences in returns can only be generated from the portion of each portfolio which is distinct.

The more similar one fund is to another, the more important price becomes as a differentiator between products. For example, UBE has 78.2% overlap with IEU, and 72.3% with VEQ. This analysis cuts through sector and country allocation data and identifies an ETF’s ‘value for money’. It is also useful in comparing ‘smart beta’ products to the more traditional pure index ETFs.

Building the investment case

There’s more though to ETF selection than sector and country allocations, fees, past performance – real or back-tested – and other minor preferences. A detailed examination of the investment fundamentals is required to build a solid investment case. Table 4 has some important fundamental factors and valuation metrics, as well as the ALTAR Score™ - our proprietary measure of an ETF’s overall investment merit (like any rating, investors should consider it alongside other criteria when making a fund selection). Our calculations are based on reported results and consensus estimates for each underlying security in an ETF.

Table 4: Investment fundamentals and valuation metrics

Importantly, the data points above give investors more information on which to make a fund selection. There are usually trade-offs in fundamental data when selecting ETFs. The ALTAR Score™ is not the only thing to look at. For example, superior Net Margins and ROE of the underlying stocks bodes well for the investment characteristics of HEUR, although its higher Price to Book Value (P/BV) impacts yield (which may show the underlying stocks are in favour with current investors).

Understanding the trade-offs

Investing in ETFs — as with almost everything else — involves trade-offs. Table 4 illustrates some of the trade-offs that result between attractive valuations and profitability and growth. The beauty here is that the transparency of an ETF shows those trade-offs clearly. With the appropriate fundamental investment data and selection tools, more informed investment decisions can be made, ultimately creating a better match between an investor’s objectives and the available funds. If you invest in ETFs, as an individual, an advisor, a robo, a super fund, whatever your stripes: what criteria do you value?

 

Michael Turner is Head of Sales & Corporate Development at AltaVista Research, which is based in the US and has been operating in Australia since 2008. As a specialist ETF researcher, AltaVista covers 1,100 ETFs in the US valued at some USD2.15 trillion. In Australia, research covers 104 equities and fixed income ETFs. This article is general information and does not consider the needs of any individual.

 

4 Comments
Chris
October 20, 2016

Personally, I’m confused by anything that is not just a plain vanilla ETF and think there’s a lot of rubbish out there (seeing as ETFs are “the new black”). My understanding is that some of them don’t even hold any underlying securities to back them ?! (and charge well over the 'passive' management fees of around 0.1% to 0.4%)

Ironically, they fit the term “synthetic” very well (I would say ‘artificial’ in the same way “sweetener” is not “sugar”), because all of these very subjective, sometimes oxymoronic terms (“deep value”) you mentioned above – I just don’t bother investing in them because I don’t understand it. If someone else can make money from it, good luck to them, but I’ll pass.

Michael Turner
October 20, 2016

Chris, interesting comment. Education via clear knowledge is the key. I will happily run you through the ETF landscape of the plain vanilla ETFs (arguably, what ETFs were first designed to be) and those that fall outside of that concept. Yes, fees and underlying holdings do vary, usually in line with these variations and by product type, if you will.

Michael Turner
October 20, 2016

Indeed Ashley, they do - and then some. Though, arguably, not as detailed a set of quantitative analytic data as we - and our advisor clients - would suggest is needed for building a fully informed, client specific investment case. Indeed, this combined with the use of effective comparative and selection tools, is the true subject of the article, which I am sure you appreciate.

Ashley
October 19, 2016

Worth noting that every ETF publishes daily their holdings and perhaps other data such as country exposures, etc.

 

Leave a Comment:


RELATED ARTICLES

How ETFs and indexes cope with company delistings

An intriguing theory explaining persistent LIC discounts

Two overlooked tax advantages of investing in ETFs

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

Welcome to Firstlinks Edition 583

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Latest Updates

Planning

What will be your legacy?

As we get older, many of us start to think about how we’ll be remembered by those left behind. This looks at why that may not be the best strategy to ensure that you live life well and leave loved ones in good stead.

Economy

It's the cost of government, stupid

Australia's bloated government sector is every bit as responsible for our economic worries as the cost of living crisis. Grand schemes like the 'Future Made in Australia' only look set to make it worse.

SMSF strategies

A guide to valuing SMSF assets correctly

SMSF trustees are required to value all fund assets, including property, at market value when preparing the fund's financial statements each year. Here are some key tips to ensure that you get it right.

Economics

Australia is lucky the British were the first 'intruders'

British colonisation's Common Law system contributed to economic prosperity, in contrast to Latin America's lower wealth under Civil Law. It influenced capitalism's success in former British colonies, like Australia.

Economics

A significant shift in the jobs market

The expansion of the 'care sector' represents the most profound structural change to Australia's job market since the mining boom. This analyses how it's come about and the impact it will have on the economy.

Shares

Searching for value in tech stocks

Just because a stock is cheap doesn't necessarily make it good value. This uses case studies in the tech sector to help identify when stocks trading on 30x earnings may be inexpensive and when others on 10x may be value traps.

Investing

Are more informed investors prone to making poorer decisions?

Finance Professor Michael Finke recently discussed the double-edged sword of taking an interest in your investments, three predictors of panic selling, and why nurses tend to be better investors than doctors.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.