Future Focus: Red flags for ETFs
What should investors avoid?
Sharesight gives us insights into what Morningstar subscribers are buying and selling. In the time that I’ve been at Morningstar, I’ve seen the slow but steady shift of the top trades each month moving from blue chip stocks to Exchange Traded Funds (ETFs).
There’s huge flows going into these products. Over 2 million Australians now hold ETFs in their portfolio. Betashares research shows that some of the main reasons are diversification, access to overseas markets, building a good portfolio core and access to specific asset classes.
ETFs are solving many problems for investors, but they’re unfortunately not built equal. There are red flags to look out for with these investment products. The Sharesight data is consistent month to month and the same ETFs keep topping the list. To me this indicates that investors are choosing an ETF and making regular contributions. If you are making regular contributions into an ETF it makes the initial choice of an ETF even more crucial.
There are some obvious red flags that investors intuitively know to steer clear of – high fees, low liquidity, poor performance. Here are three lesser-known red flags to look for when you are choosing an ETF.
Tracking error
Tracking error measures how closely to the index an ETF is tracking. If the ETF is not following the index closely, there is a high tracking error. If the ETF mirrors the index exactly, it has no or low tracking error.
Evaluating tracking error requires context. Tracking error for a passive ETF should be low as the investment objective is to provide a return that matches an index. Tracking error for an active ETF should be high as you are paying a manager to invest differently from an index while achieving your objective.
Below you can see the top 20 largest ETFs in Australia and their tracking error.
Jose Garcia Zarate, Senior Principal, Manager Research, at Morningstar, writes:
“A useful analogy to understand these concepts is that of a race between two cars, where one car is the index and the other is the fund. Tracking Error tells you how close the two cars were to each other during the race.”
He gives the following example to calculate the tracking error:
- Tracking Error = Standard Deviation of (P–B)
- P = the return of the investment
- B = the return of the benchmark
Assume there is a fund benchmarked to the ASX200 index with fund and index returns as follows over a five-year period:
The standard deviation of this series of differences, the tracking error, is 2.8%. If the sequence of return differences is normally distributed, it can be expected that the fund will return within 2.8%, plus or minus, of its benchmark approximately every two years out of three. This manager is a benchmark hugger.
Investors should also expect a fund with less volatile investments, such as bonds and loans rather than equities, to have a lower tracking error.
For passive investors the objective is exposure to the chosen market or sector. For active investors objectives will vary and may include higher returns, lower volatility or higher income. All of these objectives will be different from cheaper passive indexes.
A weak methodology or a history of deviating from it
Part of the allure of ETFs is that they offer investors a hands-off approach. Investors invest in an ETF, and they let a fund manager either choose the investments or follow an index that offers a desired exposure.
Where this can go wrong is when investors buy funds that have vague objectives or goals. It’s hard to match the exposure that you’re looking for in your portfolio to a vague methodology and trust that the ETF will deliver what you’re looking for in the long term.
The good news is that ETFs disclose all held securities so investors have transparency into the underlying holdings. However, it’s important that these securities that are held match the original objectives of the fund.
When an ETF changes its methodology
Part of choosing any investment is understanding what you’re getting yourself into. When you’re assessing an ETF to invest in, the methodology or investment objective is one of the core factors to look at.
Let’s take Vanguard Australian Shares Index VAS for example:
Vanguard Australian Shares Index ETF seeks to track the return of the S&P/ASX 300 Index before taking into account fees, expenses and tax.
The investment objective will tell you what the ETF will and won’t invest in and what the investment is trying to achieve. The objective will guide investment decisions by the ETF managers and give you peace of mind that you are getting the correct exposure in your portfolio.
There are a few reasons why the objectives may change during the lifetime of holding an investment:
- The methodology is changed
- Active managers make decisions that do not align with the objectives of the fund. For example, if you have a vague methodology to invest in ‘Innovation’ companies or ‘Disruption’. It is easy for active managers to use their discretion to decide what that entails. This may be what you want, but it also lends itself to circumstances where they deviate from the objectives of the fund.
- Market movements mean that you may have over or under exposure to certain investments, sectors or geographies.
This isn’t just theoretical. Any of the above occurrences can drastically change the profile of your investment. One example is when iShares owner BlackRock changed the index that a few of their ETFs tracked in 2022. One of their most popular ETFs iShares Core MSC World Ex AUS ETF IWLD turned into iShares Core MSC World Ex AUS ESG ETF IWLD. They put an ESG tilt on this ETF with global exposure.
As an investor, this is an alarming decision. Previous investors weren’t given a choice about whether they wanted to track an ESG index. The switch in the index likely results in capital gains as sectors, companies and non-ESG friendly investments were sold. The overall profile of the investment may no longer align with the goals of investors.
Checking the underlying holdings against the methodology should be a mandatory step in your annual or half-yearly portfolio reviews. If the exposure in the investment no longer suits your goals or fits into your portfolio, it may be time to assess whether it still deserves a place or needs to be replaced.
Thematic ETFs with vague objectives
Thematic ETFs are trying to capitalise on themes that appeal to investors. That is what brings the funds in. You may be eager to try to get exposure to a seemingly trendy investment that gives you access to the AI gravy train, or the broader technology gravy train. Whatever train you’re looking to board, proceed with caution.
A good example of an ETF with vague objectives is FANG+ ETF with the ticker symbol FANG. It tracks the NYSE FANG+ index that is made up of ‘highly-traded’ tech giants that are selected by a governance committee. The criteria for inclusion requires a share to be a highly-traded growth stocks of technology and tech-enabled companies in the technology, media & communications and consumer discretionary sector.
Confused as to what that means? Me too. The criteria is simply finding expensive and popular stocks. This means you’re buying an ETF that is chasing the performance of popular investments after a period of strong performance. The ETF has 10 holdings that are equal weighted and rebalanced quarterly.
The vague objectives and active discretion means that you may not know what you’re investing in. You may hold companies that sit outside of the exposure that you want due to the broad criteria.
Discretion can be a good thing if it provides an active ETF manager the opportunity to find opportunities. But it can also be an issue if you are investing is something you don’t understand.
Final thoughts
ETFs can be great tools to help you reach your financial goals, and more investors are using them to do so. Ensure that they align with what you’re trying to achieve and do what they say they’re going to do. Like with anything in investing, doing the appropriate due diligence before you invest and when you are maintaining your portfolio will keep you on track.
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