ETF Fit: Does My ETF Give Me The Exposure I Really Want?

We believe most investors choose an ETF to express an investment opinion, and to access the pattern of returns expected from that opinion.

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We believe most investors choose an ETF to express an investment opinion, and to access the pattern of returns expected from that opinion, e.g., gold will rise, large-cap U.S. stocks will fall, Treasury bonds will provide a certain level of risk-adjusted return. The proliferation of ETFs has made it both possible and daunting for investors to find the fund that best expresses their precise views.

It is therefore important for investors to understand exactly what an ETF holds, and how it comes to hold the securities in its basket. For example, there are 63 different broad-based U.S. large-cap ETFs to choose from. Investors may assume that they are all the same because they all pull from the same universe of 300—or 500, if you believe the S&P 500 is a large-cap index—U.S. listed stocks, but this is a dangerous line of thinking. There are equally weighted, fundamentally weighted, volatility weighted large-cap funds whose exposures and risks vary, sometime greatly.

To help investors navigate the various funds at their disposal, we created our Fit scoring.

To measure Fit in equities, first defines each fund’s market segment, and then compares a fund’s performance and holdings with those of a benchmark that reflects the segment as a whole. The benchmark we have chosen for every segment of the market is the index we feel captures the neutral market best. This process is grounded in the following principles:

We expect that:

  • An investor should be able to understand and predict the pattern of returns a fund will deliver under particular market conditions, in relation to the returns of the broad segment.
  • Claims of outperformance should be held to a high standard of proof.
  • Investors should be completely informed about the specific exposures that a fund carries, and should understand how those compare with the broader segment’s exposures.

You can therefore think of the segment benchmark as a landmark. If you want true large-cap exposure, the only way to determine how well an ETF tracking the S&P 500 captures the U.S. large-cap market is to compare with a neutral large-cap index. The same holds true if you’re trying to capture the Latin American equity market, the Chinese equity market or the total market capitalization of frontier markets.

The Fit scores signal how closely a fund resembles its Segment Benchmark. A high Fit score indicates similarities; a low Fit score announces significant differences. Further, the Fit scores alert an investor to pay attention to a fund’s strategy and exposures. Simply put, the higher the Fit score, the better the fund resembles the broad market. For example, if a fund’s strategy claims to pick “winners” through a proprietary index methodology that uses things like momentum and/or value, it’s important to understand what sector biases come from that process and if there’s any real outperformance—not just size or style biases that increase risk.

This concept can be applied to all asset classes. In the equity space, the neutral market is defined by as the cap-weighted view of the market. All funds in a given segment are compared with a cap-weighted index of the securities defined by a given segment. For U.S. large-caps, we use a cap-weighted index of U.S. large-cap firms. For the Chinese total market, we use a cap-weighted index of Chinese firms spanning the entire cap spectrum. For Japanese small-caps, we use a cap-weighted index of Japanese small-cap firms, and so on. We then compare all of the funds in each segment with this benchmark in terms of their sector tilts, cap bucketing, average market cap, holdings overlap and regressional analysis, among others.

Once you get beyond the equity space, there are different ways of measuring the neutral market and comparing exposures.

In fixed income, we define the neutral market as a value-weighted index of bonds in a given segment. We then compare each ETF in a given segment with that value-weighted view of the market in terms of sector tilts, interest and credit risks, maturity bucketing and portfolio length. As with equities, we regress each fund against our segment benchmark to compare the return profile of each ETF with the neutral market. Again, the goal is to provide investors with a reasonable landmark of comparison.

In the commodities space, we use a front-month, production-weighted index to capture the neutral market. In the currency space, we compare the spot price of a given currency to the ETFs covering that currency. In the alternative space, we analyze the correlation of each ETF to various global asset classes, with the belief that investors considering long/short and various total-return strategies invest in these products in an attempt to get noncorrelated returns. In every case, we fine-tune the relative analysis to reflect the key statistics investors use to compare and contrast portfolios and strategies.

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