ETF Due Diligence: Chasing Quality, Not Performance

November 03, 2017

ETFs that offer broad-based, cap-weighted coverage of a well-defined market segment are built to reflect the market rather than outperform it. In order to outperform the market, a fund has to offer exposure to risks that are different from the market baseline, aka relative risk. No relative risk means no outperformance, and no underperformance. There’s nothing to chase. 

ETF Analytics’ Fit score gives high marks for minimizing relative risk.

For example, the iShares Core MSCI Europe (IEUR-US) scores a 99 for Fit, because it provides broad-based, unbiased coverage of the developed European equity markets. By contrast, WisdomTree Europe Hedged Equity Fund (remember the hot money flowing into HEDJ?) holds a narrow portfolio of export-oriented firms that pay dividends, weighted by annual cash dividends paid with specific caps, with a currency hedge overlay. Investors have to get four bets right to win with HEDJ: Europe, exporters, dividend emphasis, currency hedge. That’s why HEDJ scores 39 in Fit.

These portfolio differences make for vastly different returns. While HEDJ had an excellent month (as of 10-27-17), it trailed badly over the six-month lookback, even against other currency hedged or “smart beta” funds like DBEU and EUMV. 

 

ETFExplainerXLB

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

 

ETF Analytics’ Fit score rolls up portfolio comparisons and the returns difference analysis. Investors who prefer to ride the mean, rather than watch their investments surge and fall back in potentially costly mean reversion need only search out a high Fit score. While these investors will bear market risk that comes with exposure to the segment, they can at least avoid relative risk. For those who prefer to make tactical bets, the Fit score allows for a quick assessment of the active risk chosen.

Analyst Pick, a designation granted to one fund per segment, combines classic ETF due diligence and a straightforward investment philosophy that minimizes active risk. FactSet’s ETF Analyst Pick recommends ETFs that investors can hold for an extended time—for as long as they want exposure to a market segment. Analyst Pick is the antidote to performance-chasing.

By applying basic cost and liquidity thresholds, Analyst Pick narrows each segment’s offering to the funds that are cheap and low risk to hold, and easy to trade. Next, the methodology selects the simplest vanilla investment strategies, favoring those with the highest Fit score.

Here’s how it works within the US Total Market Equity segment—a favorite for long-term equity exposure. The ETF Analyst Pick, Vanguard Total Stock Market ETF (VTI-US), posts a headline expense ratio that is 0.01% higher than the segment low, but executes as if it were even cheaper, with a median -0.01% annual tracking difference. VTI is cheap to trade at a 0.01% spread. Most importantly, VTI’s Fit score of 99 assures investors that the fund does what it claims to—gives exposure to the US Total Market—without making bets against the market.

The table below, from FactSet’s new ETF screener, makes it clear why VTI stands out in this crowded segment.

 

ETFExplainerXLB

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

 

ETF due diligence works best when costs and risks are foremost. Low cost, liquid, well-run funds preserve investor capital for taking desired risks, such as exposure to a particular market segment. Pointing to the odds-on bet of broad-based, cap-weighted exposure helps position long-term investors to avoid active risk and costly performance-chasing.  

At the time of writing, the author held VTI, in mutual fund format. Elisabeth Kashner is the director of ETF research and analytics for FactSet.

Find your next ETF

Reset All