The first four questions you should ask when assessing an ETF

When you are selecting an ETF to invest in, the most important feature to assess is the index the ETF aims to track. To be a ’true to label’ ETF, one of the criteria is that the fund’s objective must be to track a reference index. It is therefore the reference index that drives the performance and risk outcomes of the ETF. While the fees, the expertise of the issuer and the way the ETF replicates its index are also important, these considerations should only be assessed once you fully understand the ETF's reference index.

There are four critical questions for investors to ask when assessing an index:

1. Does the index match your investment objectives? Your ETF investment, and therefore the index it tracks, should match your risk profile and the outcomes you are trying to achieve. You need to understand the purpose of the index, such as exposure to an equity or bond market, any specific sector or country concentration or currency risks.
   
   
2. Is the index concept supported by research and experience or is it a fad? Index design should be supported by reputable research and not just be a short-term fad.
   
   
3. Is the index method easy to understand? Could you explain the index to someone else? If not, do you really understand what investment the ETF is offering?
   
   
4. Has the index performed as you would have expected? The index’s historical data should be readily available so you can assess the past performance of the index to determine whether it has done what it claims to do.

Considering these questions is easier said than done, so below we outline a few approaches and some examples to help.

Does the index match your investment objectives?

You need to pick ETF exposures that match your investment objectives. If you are not sure what your investment objectives should be, a financial adviser can help. As all investing involves risk, an adviser can help you identify which risks you can live with and which you should eliminate, to help achieve your goals.

One of the advantages ETFs provide is instant diversification, which is typically a key objective, with only one trade. There are a two easy steps to determine whether you will get what you expect.

1. Check the asset allocation and holdings. Most ETFs are fully transparent, so you can check these details on a daily basis on the issuer’s website.
   Your adviser will tell you that a diversified portfolio will give you better potential to achieve growth over the long term than a concentrated portfolio will. So for Australian equities you may consider a fund that tracks the S&P/ASX 200 which captures the top 200 companies of the Australian share market, investing in those companies proportionally, based on their market capitalisation. However a review of the sectors and the stock weights in that index reveals that if you are seeking diversification, the S&P/ASX 200 may not be such a great index after all. Financials make up around 40% of the index. The top 20 companies represent nearly 60% of the index. An investor buying a fund that ostensibly contains 200 stocks would likely assume that there would be better diversification.
   
   
2. Check the returns of the underlying holdings. It is also worth reviewing the returns of each of the stocks in the ETF’s underlying index. If it looks like you can buy just one or just a few of those stocks and still achieve your objective, it makes sense to do so rather than purchase the ETF, which will have a fee. Doing your homework here can help you identify indices that you should avoid.
   A well-diversified portfolio will have stocks that sit on either side of the index’s return at different times. It is a sign of poor ‘invest-ability’ if only one or two stocks contribute to the index’s overall performance all of the time. A review of Australia’s health care sector provides a good illustration. The S&P/ASX 200 Health Care Index has done well over the past five years returning 28.90% p.a. (as at 30 June 2020). An analysis of the returns shows that out of the 21 stocks in the index, only 3 returned more than sector’s overall return. The three stocks that that outperformed were mega-cap CSL, New Zealand’s Fisher & Paykel Healthcare and the cross-listed US-based Resmed. This imbalance indicates that this index is not ‘investable’ which may explain why no ETF issuer has a fund that tracks this index. The same analysis can show that there are other S&P/ASX sector indices in which the returns of one or two stocks dominate, indicating that acquiring those few shares would be better than investing in an ETF that uses the index for that sector.

Is the index concept supported by academic research and experience, or is it a fad?

Speculators follow fads. Investors do not. Financial advisers can provide investors with robust rationales as to why particular indices are suitable or preferred. They may cite modern portfolio theory, the theory of efficient markets or some other piece of well-regarded, well-known research.

There is a lot of academic and commercial research about investing and investment products that is freely available online. Additionally, an ETF issuer’s website and the index provider’s website should both have freely available information about the index, its holdings and the supporting research. If you don’t feel like doing the leg work, give your ETF provider a call – they’ll likely be happy to point you in the right direction.

Is the index method easy to understand?

The index methodology is the set of rules that determine which securities are included in the index from time to time and therefore what your money will be invested in. The index method should be easy to understand. The S&P/ASX 200, for example, is quoted in the media every day and is the barometer for the health of the Australian market. Most investors understand that in a market capitalisation index like the S&P/ASX 200, a company’s weight in the portfolio is determined by its size. Likewise, an equal weighted index is easy to understand in terms of construction: each holding is equally weighted.

Has the index performed as you would have expected? Has it been ’true to label’?

This involves checking the returns of the index and considering whether it has performed as you would have expected in varying market conditions. The returns of the index should be readily available on the ETF issuer’s or index provider’s website. For example, you would expect a broad Australian equity market capitalisation index such as the S&P/ASX 200 to rise 2% if the media reports the Australian share market rose 2% that day. Digging further into the S&P/ASX 200, because it is a market capitalisation index and the largest companies have the biggest impact on its performance, if Australian banks do well, so too you would expect the S&P/ASX 200 to do well.

Likewise, if the research you did earlier when you were assessing a more specialised index, suggested that index would be defensive in times of a market sell-off, then that specialised index should not have fallen as far as the market index did during a sell-off.

Once you have the answers

If you are comfortable with the answers you get to the four questions above about an ETF's index, you can move on to considering the fees, the expertise of the issuer and the way the ETF replicates its index (hint: choose physical over synthetic replication).

You now have a robust framework and know where to find the tools to assess the index that underlies the ETF you are considering. The index is the most important consideration as it will drive your investment performance.