Part 2: Index Investing

In part 1 of our index investing blogs, we explored some of the crucial ways that seemingly similar index ETFs can be very different. We focused on variations in index exposure (the index an ETF tracks and that index’s methodology) and product structure, and how those differences can affect your returns.  

In this second part, we delve into the differences in index ETFs when it comes to total cost of ownership (it’s not just about management expense ratios) and the amount of support investors and advisors get from the ETF provider. We’ll see further proof that index ETFs can be far from equal.

 

The true costs of ownership

Many investors compare management fees or management expense ratios (MERs) when comparing index ETFs. While these are important recurring costs for investors, they aren’t the only ones you need to consider.

This is particularly the case in categories where the fee differences between ETFs are negligible. When it comes to the total cost of ownership for ETFs, you also need to consider trading costs and costs related to the ETF’s performance. These will vary, depending on how long you intend to invest in the ETF.

Costs arising from trading ETFs generally include the following:

• The bid-ask spread (the difference between what a seller is willing to accept and what a buyer is willing to pay) is the main cost of trading, after commissions
• Premiums or discounts in the market price to the net asset value (NAV) of the ETF
• Any brokerage commissions to execute the trade

These costs only happen when you buy or sell ETFs, so, typically, the shorter the period that you hold onto the ETF, the more these transaction costs impact the total cost of ownership.

 

Performance costs

You could argue that costs related to the ETF’s performance are more meaningful for most investors, as they happen on a regular basis. Unlike with trading costs, the longer you invest in an ETF, the more these performance costs matter. These costs typically include the management expense ratio (MER), trading expense ratio (TER) and taxes (including capital gains and withholding taxes). Investors should also keep in mind that the structure of an ETF — and the index it tracks — can have impacts, including rebalancing costs.

For many investors, keeping costs low in index investing is essential, but performance should be equally important. Index investors want the ETF to track index performance as closely as possible.

An index ETF’s performance is measured by its tracking difference and its tracking error. Tracking difference is the amount that the ETF returns above the index return. Tracking error is when a fund brings returns that are below those of the index.

While index ETF portfolio managers attempt to match the index’s performance as closely as possible, the tracking difference is rarely flat. There are several factors that can mean an ETF doesn’t perfectly copy its index, including:

• Fees: Even the lowest management and trading fees can cause a tracking error
• Diversification rules: For example, in the US, ETFs cannot hold more than 25% of a single stock, which can make it impossible to truly replicate certain indices
• Securities lending: As outlined in part one of this blog, fund managers that lend securities can increase an ETF’s returns with the interest charged on the borrowed stock

 

Support from the ETF provider

The role of ETF providers is not only to provide well-constructed, effective investment solutions that help investors achieve their goals. They also have a responsibility to provide valuable perspectives and ETF education. Understanding how an ETF provider plans to manage ETFs over time and through market volatility, while providing investment insights and product support, is also important.

It’s also critical to consider the ETF provider’s experience, expertise and commitment to the ETF industry. They also need to have good relationships with partners, such as liquidity providers and market makers, as these are the channels through which investors will trade.

Index ETFs can vary greatly in the ways that they’re constructed and managed, and this can have a big impact on how they perform, particularly in challenging markets. Investors will typically look at index ETFs’ total assets, on-screen volume and management fees before making a decision. However, these shouldn’t be the only metrics they rely on.

 

What to look for to spot index ETF differences

Now that we’ve examined the ways that index ETFs differ, what should you, as an investor or advisor, be watching out for? Let’s take a look:

Index exposure: Search for index methodologies using Google. Compare various index methodologies across key areas, such as security selection, index weighting, rebalancing frequency, market capitalization definitions and any style/sector/theme definitions. You want to be able to understand the key similarities or differences between two similar ETFs that track indexes from different index providers.

For ex-Canada indices, consider whether a Canadian tax schedule is being used for withholding. If it isn’t, expect to see a tracking error between the ETF and this index, because the ETF would be receiving income net of a Canadian withholding tax schedule.

Product structure: Look at whether the Canadian-listed ETF invests directly in securities or bonds, or if it invests in a US-listed ETF. The underlying structure may have an impact on your returns.

Cost of ownership: If you are investing in an ETF for just a few weeks, spread and premiums/discounts matter greatly. If you’re investing for months or years, management fees and taxes are your most important recurring costs. For ex-North America equity, for example, look at historical withholding taxes paid on the ETF.

This information can be found in financial statements for the ETF. If the Canadian-listed ETF invests in a US-listed ETF, consider the various layers of withholding tax impact. Also, review capital gains distributions from prior years. If the ETF is realizing more capital gains than other similar ETFs in the category, consider this potential tax impact as part of your total cost of ownership.

 

Support from ETF providers: Look for thought leadership in the form of investment insights, blogs and whitepapers on ETF providers’ websites.

Find out more about how to spot the differences between index ETFs: for advisors, speak with your Mackenzie sales team; for investors, talk to your financial advisor.