Does The ETF Provider Matter?

October 25, 2010

Does it matter whether you buy ETFs from iShares, Vanguard, State Street or some other provider?

The question jumped out at me after I read about the most recent Cogent ETF study, which found advisers diversifying their loyalty from iShares to other companies, such as Vanguard. I don’t find the study surprising, nor do I see it as damaging to iShares. Other ETF companies are getting bigger and are starting to offer the kinds of services iShares has offered for years, thereby deepening their relationships with advisers.

A few years ago, for instance, iShares and State Street were the only companies offering serious trading support to advisers. Now every bit player is staffing up a capital-markets desk to watch spreads and help route large trades. The result has been a narrowing of spreads throughout the ETF industry, and generally better liquidity in ETFs large and small.

But still, the Cogent study raised a question: Does the choice of provider matter?

Most of the time, I would say no. What matters most when selecting an ETF is selecting a fund that tracks the right index. iShares may be a great ETF manager, but nothing could convince me that the iShares FTSE/Xinhua China 25 ETF (NYSEArca: FXI) is the best China ETF on the market. FXI’s mega-cap tilt ignores the bulk of the Chinese market, and I’d rather have a more diversified fund from a lesser player in the industry.

Or, to look at the most plain-vanilla category in the ETF market, the difference in performance between the best- and worst-performing large-cap U.S. ETF—the First Trust Large Core AlphaDex (NYSEArca: FEX) and the Rydex Russell 50 (NYSEArca: XLG), respectively—was more than 10 percent. Nothing an ETF provider can do could make up for that kind of difference.

Still, if you look past obvious difference like the index and expense ratio, there are reasons to favor one fund provider over another.

Factors To Consider

One is size. All else being equal, many advisers favor larger, more-established providers over smaller shops. We’ve seen a number of small ETF companies go bust over the years—FocusShares, HealthShares, SPA ETFs, etc. Advisers recognize that tiny upstarts have a greater risk of shutting down funds. That’s not the end of the world: Investors get their money back when ETFs close. But it’s no fun either, and can create an unwanted tax event. If an upstart is offering a unique fund, it makes sense to buy it. But if it’s a me-too product, why take the risk?

Another area to consider is support. Here, surprisingly, there’s no easy rule. One might think that the largest ETF companies provide the best support, from core educational services to practice management and trade support. But the truth is it varies from ETF provider to ETF provider. iShares is famous for its adviser support services, and rightfully so. Vanguard is picking up the pace. But there are some small firms that are extraordinarily supportive of advisers, and large firms that have trouble answering the phones. Unfortunately, this is one area where personal relationships matter.

A third area to consider is portfolio management. I haven’t seen a study yet comparing tracking error across ETF providers, but it would be an interesting piece of research. Do certain ETF companies do a better job managing funds than others? It’s worth looking into.

A fourth, and related area, is tax management. Most ETF providers run a tight ship on taxes. But for whatever reason, certain ETF providers seem to do an incredible job. iShares, Vanguard, PowerShares and Van Eck come immediately to mind as providers that run hundreds of funds and almost never pay out capital gains distributions. They deserve kudos for doing a good job.

A fifth area to consider is share lending. Many ETF providers engage in share lending, which involves lending out the individual stocks held inside an ETF portfolio to short-sellers in exchange for a fee. I’m a firm believer in share lending, and think it’s a sensible way for an index fund to deliver enhanced performance with relatively low risks. But if a fund company is going to lend shares, all of the revenue from that activity should go back into the fund.

We recently published a study of ETF share-lending policies in ETFR. The list of companies with active share-lending policies that return 100 percent of the proceeds after fees to shareholders is relatively small: Vanguard, Van Eck and Rydex were among the few that commit to it. iShares, to take the other side, takes 35 to 50 percent of the revenue from lending and allocates it to the fund.

One last area to mention is transparency. Certain ETF providers disclose their full portfolios every day. Vanguard, however, only discloses its portfolios quarterly with a 30-day lag. iShares discloses some portfolios daily, but only lists its MSCI-linked portfolios on a quarterly basis.

While both iShares and Vanguard do a good job running funds, I’d prefer it if they disclosed their portfolios in full.

In the end, however, these factors pale in comparison to index selection. Choose the right index, check the expense ratio and monitor the trading spreads, and you’ll end up in a good place.

Choosing the “best ETF provider” is just a cherry on top.

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