ETF Due Diligence: Chasing Quality, Not Performance

November 03, 2017

Analysis of these costs and risks allows us to differentiate between funds with similar mandates and equal expense ratios, such as the iShares TIPS Bond ETF (TIP-US) and the PIMCO Broad US TIPS Index ETF (TIPZ-US). Both funds cost 0.20% per year, but the iShares product tracks its index more closely, and trades with higher volumes and much lower spreads. That’s why FactSet ETF Analytics gives TIP an A letter grade, and TIPZ a B. 



For a larger view, please click on the image above.


Costs can add up over time. An investor who chose the A-rated ETFS Physical Platinum Shares (PPLT-US) over the F-rated iPath Bloomberg Platinum Subindex Total Return ETN (PGM-US) for a one-year holding period would have held onto an average of 2.53%, based on the median tracking difference and average spreads. That’s a huge performance boost, with no market risk.



For a larger view, please click on the image above.

Performance analysis simply is not a part of an assessment of operating and trading costs. Instead, we look at fund performance and market risk is a separate section, called Fit.

ETF Analytics’ Fit score ranks funds on the basis of active risk. A score of 100 indicates the fund completely reflects its opportunity set; a score of zero points to extreme bets against the market. Fit measures relative risk, without extrapolating returns.

Why not returns? It turns out that historical performance—even rigorously measured, statistically significant outperformance—is an unreliable predictor of future performance. 

This second point is worth taking first. In the ETF universe, risk-adjusted outperformance that passes even the most basis tests of statistical significance is hard to come by. And it’s not just because vanilla ETFs are built to mimic the market rather than outperform. It’s worse. Any time I’ve tested the risk-adjusted returns of “smart beta” ETFs that promote their potential for outperformance, the vast majority perform in line with risks taken; not over, not under. Last time I did this, with a five-year look-back as of March 31, 2017, only 8.8% of the 53 funds I tested delivered positive alpha at the generous 90% significance level. In layman’s terms, most of the raw over- and underperformance was attributable to risk and statistical noise.

Even at the simple level—raw performance—persistence of returns turns out to be vanishingly rare. Just ask Aye Soe and Ryan Poirier, authors of the semiannual SPIVA study, who explained, in their June 2017 Persistence Scorecard, ”no large-cap, mid-cap, or small-cap funds managed to remain in the top quartile at the end of the five-year measurement period. This figure paints a negative picture regarding long-term persistence in mutual fund returns.” They went on to say, “The data show a stronger likelihood for the best-performing funds to become the worst-performing funds than vice versa.”

In other words, performance chasing is often quite costly.


Find your next ETF

Reset All