Don’t Select An ETF On Reputation Alone

[This article was first published on our Learn section, a comprehensive database or educational articles]

Does the brand or issuer matter for an ETF? Are some better than others?

In general, no.

Like most retail brands, there are generalizations to be made, but you shouldn’t select an ETF on reputation alone, any more than you’d buy a pair of shoes without trying them on. In some people’s opinion, Nike makes a great shoe; for others, New Balance is the way to go. One shoe is wider and has a higher arch, but there’s no right or wrong answer there—it depends on what works for you.

Taking the analogy further, even a runner who strongly prefers Nike is unlikely to look for Nike dress shoes. Similarly, an issuer that excels in currency-hedged emerging markets ETFs might not be your go-to for domestic large-cap stocks. Rather, the products need to be evaluated on an individual basis.

It follows that ETF brands and their corresponding issuers are not among the most important factors when selecting an ETF. ETF management companies with no reputation can produce great products. Reputable stalwarts occasionally have products that will make little sense in your portfolio. In most instances, it makes sense to place greater emphasis on the actual product offering—the ETF itself—rather than focusing on the issuer who produced it.

That said, certain factors are often companywide policies: Replication type, securities lending and structural conflicts of interest are a few. In these cases, taking the issuer into account is reasonable.

Each of these topics is discussed in separate articles, but the major takeaway is that there is no clear-cut “right” policy. Rather, they need to be evaluated on a case-by-case basis. Still, a brief summary of each issue is appropriate.

Securities lending is when an ETF loans out securities in its portfolio to short-sellers in exchange for collateral (usually well in excess of the value of the loaned securities) and a fee. It can generate additional revenues to the ETF, which translates to greater returns for investors. However, loaning securities can introduce counterparty risk to the portfolio. If you’re concerned about that counterparty risk, it’s worth evaluating the issuer’s policy in the event that a borrower defaults. Does the issuer make the ETF whole? Does the ETF itself bear the burden? Moreover, some issuers rebate all securities-lending revenues back to the ETF (delivering a slight boost in returns), while others take a cut of the proceeds.

Replication type is another policy that is often decided on a firm-wide basis. Some issuers explicitly state the objective to fully replicate underlying indices whenever possible. Others may take a different stance and try to serve their customers best by pursuing the potential cost savings that accompany optimized portfolios. Again, there’s no right or wrong answer, but those who prefer certainty—as opposed to leaving judgment to portfolio managers—may prefer issuers that attempt to fully replicate their ETFs’ underlying indices.

Structural conflicts of interest are another issue. Extra caution may be warranted for ETFs where the issuer is also the AP and/or the swap counterparty (for synthetic ETFs) as there is a potential for perverse incentives.

Lastly, and perhaps most importantly, there is another instance where brands may be helpful for investors: costs. Some issuers are dedicated to low-cost offerings, while others attempt to deliver more by charging more. Study after study has concluded that an ETF’s expense ratio is the single best indicator of future tracking difference. It follows that lower costs should equate to lower tracking difference and greater returns for investors.