ETFs are one of the fastest-growing ways to invest, but not all ETFs are created equal.

In this episode, Mark and Shani break down the lesser-known red flags investors should watch out for before adding an ETF to their portfolio.

From tracking error to methodology changes to vague thematic funds, they explain what these risks mean in practice.

In this episode, you’ll learn:

• What tracking error really means (and why context matters)

• Why vague or shifting ETF methodologies are a problem

• How mandate changes (like ESG tilts) can alter your exposure

• The risks of thematic ETFs

• How to check if your ETF still aligns with your goals

• Why due diligence and periodic reviews matter

You can find the full article here.

You can find the transcript for the episode below:

Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Shani Jayamanne: We’ve got an exciting episode today. Things have changed. We’ve got nothing on our faces, or heads.

LaMonica: Our ears.

Jayamanne: Ears. Yeah.

LaMonica: Yes. The headphones don’t work.

Jayamanne: No.

LaMonica: But people are complaining about them saying that we were World War II bomber pilots or something.

Jayamanne: Yes. So, everything happens for a reason.

LaMonica: Exactly. Well, first, why don’t you share the exciting news from today?

Jayamanne: The exciting news is that we’ve gotten our book. So…

LaMonica: Which we’re excited about.

Jayamanne: We are. Mark is unhappy with the paper quality. But…

LaMonica: I just said for our next book, we’ll have glossy paper.

Jayamanne: Glossy. Okay. Like a picture book.

LaMonica: Exactly. And then there’s another exciting announcement. Why don’t you tell people what you have been doing all day so far?

Jayamanne: We passed our audition. So, we’ve been recording the audiobook, which is why my voice is a little bit croaky at the moment. We’ve been doing… Well, I’ve started. So, 3.5 hours of recording today.

LaMonica: I start tomorrow.

Jayamanne: It’s interesting. I have a lot of sympathy for anyone who has ever recorded an audiobook.

LaMonica: Well, there you go.

Jayamanne: Yes.

LaMonica: So that will be out around the same time as the print book, which is October 8th.

Jayamanne: Yes.

LaMonica: So anyway, that’s exciting. And we have an exciting episode.

Jayamanne: Yes. So today we have an episode on ETFs. And this is a topic that we know is resonating with more and more investors.

LaMonica: And Sharesight, which I think a lot of people are hopefully familiar with, it’s a portfolio tracking tool. It’s included in Morningstar’s subscription service, Morningstar Investor. And they are able to tell us every month what Morningstar subscribers are buying and selling. And, Shani, you’re the one that gets this data. And there has been a noticeable trend where things have shifted towards ETFs.

Jayamanne: Yeah, that’s right, Mark. So, in the time that I’ve been at Morningstar, I’ve seen a steady shift to the top trades in the list. They used to be pretty consistent and into the same blue-chip stocks. But now what we’re seeing is more and more ETFs top that list. And there are huge flows going into these products. Over 2 million Aussies now hold ETFs in their portfolio. And Betashares has done research into why ETFs are resonating with investors. And they’ve found that some of the main reasons are diversification, access to international markets, building a good portfolio core and access to specific asset classes.

LaMonica: And that is a good list of problems that ETFs are solving for investors. But unfortunately, there are lots of different ETFs. They are not all equal. And that’s what we’re going to talk about today.

Jayamanne: That’s right. And one more point about the Sharesight data. What we’ve seen is that the same ETFs keep topping the list each month. And what this indicates to me is that investors are choosing a particular ETF and then making regular contributions into it. And why is this important? It’s important because if you’re making regular contributions into an ETF over the long term, the initial choice of the ETF is even more important.

LaMonica: And there are some obvious red flags for ETFs that a lot of investors know to look out for. We talk about them a lot on here. So that’s high fees, low liquidity, poor performance. But today, we’re going to go through some lesser-known red flags to look for when you’re choosing an ETF. Shani, you wrote an article on this. So why don’t you start with the first one?

Jayamanne: Sure, Mark. So, the first is tracking error. And tracking error measures how closely to the index an ETF is tracking. If the ETF is not following an index or benchmark closely, there is a high tracking error. And if the ETF mirrors the index or benchmark exactly, it has no or low tracking error.

LaMonica: Okay. Sos we’re going to use an analogy from one of our colleagues. So, Jose Zarate, Senior Principal in Manager Research, to explain tracking error. He says to think about it as a race between two cars, something close to your heart as a big F1 fan, Shani, big F1 fan pre-Drive to Survive, which you always make that distinction. So, one of these cars in the race is the index and the other car is the fund. Tracking error tells you how close the two cars were to each other during the race. And so, is this a good or bad thing? Do we want a large gap between the two cars? Do we want them right next to each other? So F1 fan, take it away. What do you want in this car race, Shani?

Jayamanne: Yeah, it’s a very good question, Mark, because evaluating tracking error does require context. So, it depends on whether the ETF you’re looking for is active or passive. For passive ETFs, the tracking error 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’re paying a manager to invest differently from an index while achieving your objective.

LaMonica: And I think as most people know, you do pay more for active management, which of course makes sense. And you want to actually get something for that. So, if the investment looks exactly like the index that you could access at a much lower price, what is the point of going to active management? So, as I said, Shani has written an article on this. And within the article, she has a table where she has done some of the hard work for you. So, you’ve gone through the top 20 largest ETFs in Australia. So those are the ETFs you’re most likely, of course, to own. And you’ve looked at the tracking error across all of those ETFs.

Jayamanne: I have. And as a general rule, investors should expect ETFs with less volatile investments, such as fixed income or bonds, rather than equities to have a lower tracking error.

LaMonica: The summary is that passive investors have the objective of exposure to a chosen market or sector. For active investors, the objectives will vary, but they may include higher returns, lower volatility, higher income. And achieving those objectives will mean deviating from the benchmark or index. So, you want tracking error to be high or low, depending upon your objective and what you’re trying to achieve with the ETF.

Jayamanne: You got it, Mark. So, let’s move on to the next red flag, a weak methodology or a history of deviating from it.

LaMonica: And part of the allure of ETFs is that they offer investors a hands-off approach. So, you go and you buy an ETF, and then you let a fund manager either choose the investments that go into that ETF or follow an index that gives you the desired exposure that you want. And where this can go wrong is when investors buy funds that have vague objectives or goals.

Jayamanne: Yeah, that’s right, Mark. So, 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.

LaMonica: So, we have some good news. Unlike managed funds, which I talk a lot about in terms of transparency, the good news is that with ETFs, they have to disclose all the securities that they invest in. So, investors have transparency into these underlying holdings. But the important part of this is that the securities that are held should match the objectives of the fund, which of course should match your objectives.

Jayamanne: That’s it. So, let’s speak a little bit more specifically and go into what happens when an ETF changes its methodology. And just quickly, the methodology is the dos and don’ts of the fund. So, it’s the explanation of what the fund can and can’t invest in and what it’s trying to achieve by doing this. And this is important for investors to pay attention to. It means investors know what they’re getting themselves into.

LaMonica: And when you’re picking and choosing ETFs, the methodology or investment objective is definitely one of the core factors to look at. So, let’s go through an example, Shani, and we’ll take the largest ETF in Australia. So, Vanguard Australian Shares ETF, so VAS is the ticker. And the methodology is 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.

Jayamanne: So, 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 drive investment decisions by the ETF managers and give you peace of mind that you’re actually getting the correct exposure in your portfolio that you signed up for.

LaMonica: And that’s of course great. That’s a perfect example of how the ETF is actually tracking the objective. But sometimes that doesn’t happen. And maybe, Shani, go through a couple of the different reasons why this might be the case.

Jayamanne: Sure. So, the first is quite simply that the methodology has changed. And we’ll go into an example about this in a moment. The second is that active managers can make decisions that don’t align with the objectives of the fund. So, for example, if you have a vague methodology to invest in innovation companies or in the theme of disruption, we don’t actually know what that means when you say something like that. So, it’s easy for active managers to use their discretion to decide what that entails.

And you know what? That might be what you want. You want them to use their discretion and figure out the best investments for you. But it also lends themselves to circumstances where they deviate from the objectives of the fund.

The last one is market movements. So, meaning that you might have over or under-exposure to certain investments, sectors or geographies, just because certain investments might perform better than others. So, Mark, I mentioned a mandate change. Do you want to go into the example?

LaMonica: Yeah, one point to make here is that this obviously isn’t just theoretical. Any of the factors that Shani mentioned can drastically change the profile of the investment and also the outcomes that you actually receive.

So, one example of a mandate change is when iShares owner BlackRock changed the index that a few of their ETFs tracked in 2022. One of their most popular ETFs, the iShares Core MSCI World Ex Australia ETF, IWLD, turned into the iShares Core MSCI World Ex Australia ESG ETF, IWLD. So, they obviously added that ESG in there. And what they decided is that they were going to change to an ESG tilt with global exposure. Still getting global exposure, everything else is the same, but they’re obviously applying some ESG rules. And personally, I think both of us believe that as an investor, this is a pretty alarming decision. You’re not given a choice about whether you want to be an ESG investor or not. And you did have that choice and people obviously chose to pick a non-ESG ETF.

So, you’re not given a choice in inheriting the tax consequences from this decision. Because when you switch an index, it likely results in capital gains as you are selling off, in this case, certain sectors or companies or anything that does not adhere to those ESG criteria that they put in. And ultimately, the overall profile of the investment might no longer align with your goals. So, it is a significant change.

Jayamanne: So, checking the underlying holdings against the methodology should be a mandatory step in your annual or half-yearly portfolio reviews. And if the exposure in the investment no longer suits your goals or fits into your portfolio, it might be time to assess whether it still deserves a place or needs to be replaced. Of course, you do need to consider this in line with the opportunity cost of transaction fees and taxes that you might need to pay.

LaMonica: We’re going to move on to our last red flag, Shani. And that is thematic ETFs with vague objectives. And a lot of long-time listeners know how we feel about thematic ETFs. So, they’re trying to, in certain cases, capitalize on themes that appeal to investors, but might not always be in the best long-term interest of an investor. So, you might be investor that’s eager to try to get exposure to a seemingly trendy investment that gives you access to AI, or you might want to jump into biotech. And perhaps that isn’t really something that is more than a natural marketing approach by an ETF provider. So, Shani, I did the last example. Why don’t you get into one here?

Jayamanne: All right. So, a good example of an ETF that had vague objectives is the FANG+ ETF, with the ticker symbol FANG. It tracks the New York Stock Exchange FANG+ index that prior to 2022 was made up of highly traded tech giants that are selected by a governance committee. And the criteria for inclusion requires a share to be a highly traded growth stock of technology and tech-enabled companies in the technology, media, and communications and consumer discretionary sector.

LaMonica: Which sounds good, but if you actually think about what all those different words mean, it’s a little bit confusing. The criteria is simply finding expensive shares that were popular. And this means you’re buying an ETF that is chasing the performance of popular investments after a period of strong performance. And the ETF only has 10 holdings that are equal weighted and rebalanced quarterly.

Jayamanne: And the rules were changed for new and current investors in 2022. The index transitioned to a more formulaic approach which put rules around what the ETF could invest in. So that’s also an example of a mandate changing.

LaMonica: Okay, we’re going to do one more example. So, another thematic example is the Global Robotics and Artificial Intelligence ETF with the ticker symbol RBTZ. It tracks Indxx Global Robotics & Artificial Intelligence Thematic Index. It has broad rules to create a selection list including market capitalization and revenue derived from artificial intelligence and robotics. But once a company is on the selection list, the portfolio is constructed by an index committee deciding the top pure play robotics and AI companies by market cap. And that’s how they form the final portfolio.

Jayamanne: So, in this instance, what does pure play mean? So how is that determined?

LaMonica: I think it’s like everything else. It’s discretionary. So, it is up to the discretion of this committee. So, when you have vague objectives and an active discretion from a committee, it may mean that you don’t know what you’re investing in and you’re holding companies that sit outside of the exposure that you want because of that really broad criteria.

Jayamanne: And we’re not saying discretion is a bad thing. Discretion is exactly what makes active management active management. It gives active managers the opportunity to find investments. But it can also be an issue if you’re investing in something you don’t understand or that doesn’t fit into what you’re trying to achieve.

LaMonica: We’ve gone through three red flags. Do you have any red flags, Shani?

Jayamanne: I have many, many red flags, Mark.

LaMonica: Would you like to share any thoughts on ETFs that have red flags?

Jayamanne: Yeah, I think just a general comment that ETF can be great tools to help you reach your goals. So, we obviously ran through the reasons why investors love them at the beginning of the podcast. And they are all fantastic reasons to include ETFs in your portfolio. But like any other investment, ensure that they do align with what you’re trying to achieve and they do what they say they’re going to do.

LaMonica: Exactly. And I think it’s the same advice we give to people in general, that with any investment, do an appropriate amount of due diligence prior to buying the investment. And then when you’re doing those periodic portfolio reviews, make sure all those investments still align with your goals and objectives.

So that is our episode. Thank you very much for listening. I know Shani appreciates the fact that she does not have to speak anymore after this for her long day of recording. And we would appreciate it if you purchased our book in pre-sale or the audio book. Thank you very much.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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