The most important thing to assess when selecting an ETF

When you are selecting which ETF to invest in, the most important feature to assess is the index the ETF tracks. To be a true to label ETF, one of the criteria is the fund must track a reference index and it is this 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 investors fully understand the ETF's reference index.

There are four critical questions that investors must ask to assess an index:

• Does the index match your investment objectives? Generally, the higher risk you take with your capital, the higher return you will reap over time. Your ETF investment, and therefore the index it tracks, should match your risk profile and the outcome you are trying to achieve. Investors need to examine whether the purpose of an index, such as exposure to an equity or bond market, meets the investor's own investment objectives and risk profile.
• Is the index concept supported by research and experience or is it a fad? Index design should be supported by reputable research and have a minimum of three years' historical tested data from a reputable index provider.
• Is the index easy to understand? Can you explain the index to someone else? If you can't, do you really understand what investment the ETF is offering? The more complex it is, the more uncertain the risks and investment outcome are likely to be.
• Does the index perform as you would have expected? The index's historical data should be readily available so you can easily assess the past performance of the index to determine if it does what it claims to do, in other words, if it is true to label.

Let's now use this framework to assess two Australian equity indices.

Assessing the S&P/ASX 200 Index
Let's assume that you are assessing an ETF which tracks the standard Australian stock market benchmark index, the market capitalisation weighted S&P/ASX 200 Index.

Does the index match your investment objectives?

Exposure to a diversified portfolio of Australian equities will potentially help you achieve growth over the long term. The S&P/ASX 200 captures one version of the returns of the Australian share market, namely the top 200 companies included proportionately based on their market capitalisation. However, if you are also seeking diversification, the S&P/ASX 200 exposes investors to concentration risk. The top 10 companies represent nearly 50% of the index. The top four companies are banks. Financials make up ~40% of the index. Such concentration is problematic if bubbles form. Sector and stock concentration make sense if an investor is 'bullish' or confident the sector or stock will outperform, but investors buying a fund that ostensibly contains 200 stocks would likely assume such a broad-based fund to be much better diversified.

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

No, it's not a fad. Market capitalisation weighting has been the dominant index weighting method for many years. Investing in market capitalisation indices has historically been supported by the theory of the Efficient Market Hypothesis (EMH) which was developed in 1970 by economist Eugene Fama. EMH asserts that market prices should only react to new information or changes in discount rates therefore stocks always trade at their fair value, making it impossible at any time for investors to either buy undervalued stocks or sell stocks for overinflated prices. Proponents of EMH believe, it is impossible to outperform the market through stock selection or market timing and the only way an investor can possibly obtain higher returns is by luck or by investing in riskier investments. Unsurprising there has been legitimate criticisms of EMH by investors, including Warren Buffett who has persistently beaten the market, and behavioural economists including Nobel Prize winner Daniel Kahneman.

Is the index easy to understand?

Yes. The S&P/ASX 200 is quoted in the media and is the standard Australian benchmark index. Most investors understand that in a market capitalisation index, a company's weight is determined by its size.

Does the index perform as you would have expected? Is it true to label?

Yes. If the media reports the Australian share market rose 2% it's likely the S&P/ASX 200 rose 2%. With a market capitalisation index such as the S&P/ASX 200, the largest companies have the biggest impact on its performance. Therefore, if Australian banks do well, so too will the S&P/ASX 200. Because of this skew towards large companies' returns, the S&P/ASX 200 doesn't track the overall share market as well as it tracks the performance of large listed companies. This reflects the fact that market capitalisation indices were originally designed to measure the health of the market and not with investment objectives in mind.

Assessing the MVIS Australia Equal Weight Index

Let's assume that you are assessing an ETF which tracks the MVIS Australia Equal Weight Index, which equally weights the largest and most liquid stocks on the ASX.

Does the index match your investment objectives?

Exposure to a diversified portfolio of Australian equities will potentially help you achieve growth over the long term. The MVIS Australia Equal Weight Index currently includes 79 Australian companies. The Equal Weight Index, as the name suggests, gives each stock in the index an equal weighting, so a mega cap company has an equal weighting to a large- or mid-cap company. This equal weighting strategy gives the index greater diversification than the S&P/ASX 200 Index. In fact, research shows that the Equal Weight Index is three-times better diversified than the S&P/ASX 200¹.

The Equal Weight Index reduces stock and sector concentration risk by diversifying away from financials and large resources, which dominate the S&P/ASX 200, and broadening into the other sectors of the market such as consumer discretionary and industrials.

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

Yes. It is not a fad. Equal weighting is a strategy that has been around since the 1970s and has taken off in the US and Europe in the 1990s and now in Australia, with many academic institutions such as The University of London's Cass Business School, EDHEC Business School, Goethe University and Australia's own Monash University, demonstrating the long-term outperformance of equal weight investing. These findings reinforce industry research by index companies S&P Dow Jones Indices and MV Index Solutions. The experience in Australia has also matched the research, where the Equal Weight Index has outperformed the S&P/ASX 200 Index in 11 out of the last 14 years.

Is the index easy to understand?

Yes. In fact, it's arguably as easy as it gets. An equal weight index simply applies the same weighting to all stocks to be included in the index.

Does the index perform as you would have expected? Is it true to label?

Yes. The MVIS Australia Equal Weight Index enhances diversification and is true to label. Over one, three, five and ten year periods it has outperformed the S&P/ASX 200. This is demonstrated in the graphs and tables below.

_{Source: VanEck, Morningstar, FactSet; as at 30 September 2017. The above graph is a hypothetical comparison of performance of a $10,000 investment in the Equal Weight Index and other recognised indices. Results are calculated to the last business day of the month and assume immediate reinvestment of all dividends and exclude costs associated with investing in the VanEck Vectors Australian Equal Weight ETF (MVW) which tracks the MVIS Australia Equal Weight Index. You cannot invest directly in an index. Past performance of the Equal Weight Index is not a reliable indicator of future performance of the index or MVW.}

If you can answer the four questions above about an ETF's index, and you are comfortable with the answers you get, you can now take the next steps in assessing the ETF before you invest. As a minimum, we recommend you should consider the following factors:

• Understanding the liquidity of underlying securities in the index;
• Determining whether the ETF is physically or synthetically backed;
• Assessing fees, including brokerage and other transaction costs inside the fund; and
• Examining the expertise of the ETF issuer, including their pedigree and their history of managing tracking error, that is, how closely they 'track' the index.

Our next Vector Insights will focus on these considerations.

You now have a robust framework to assess the index that underlies the ETF you are considering. It is the most important consideration as it will drive your ETF investment's performance.

_{Important notice}

_{This information is issued by VanEck Investments Limited ABN 22 146 596 116 AFSL 416755 ('VanEck') as responsible entity of the VanEck Vectors Australian Equal Weight ETF (MVW) ('Fund'). This is general information only and not financial advice. It is intended for use by financial services professionals only. It does not take into account any person's individual objectives, financial situation nor needs. Before making an investment decision in relation to the Fund, you should read the PDS and with the assistance of a financial adviser and consider if it is appropriate for your circumstances. The PDS is available at www.vaneck.com.au or by calling 1300 68 38 37. The Fund is subject to investment risk, including possible loss of capital invested. Past performance is not a reliable indicator of future performance. No member of the VanEck group of companies gives any guarantee or assurance as to the repayment of capital, the payment of income, the performance or any particular rate of return from the Fund.}

_{MVIS Australia Equal Weight Index ('Equal Weight Index') is the exclusive property of MV Index Solutions GmbH based in Frankfurt, Germany ('MVIS'). MVIS makes no representation regarding the advisability of investing in the Fund. MVIS has contracted with Solactive AG to maintain and calculate the Equal Weight Index. Solactive uses its best efforts to ensure that the Equal Weight Index is calculated correctly. Irrespective of its obligations towards MVIS, Solactive has no obligation to point out errors in the Equal Weight Index to third parties.}

_{¹ MV Index Solutions, Strong Foundations Have Equal Footings, Lars Hamich, Michael Brown}