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Commentary by David Hsu, senior equity index and ETF product specialist, Vanguard, Europe.
Exchange-traded funds (ETFs) are widely considered to be one of the most efficient means of achieving exposure to financial markets. Used as building blocks for the construction of a balanced portfolio, they have the advantage of cost-effectiveness, with the compounding benefit of low charges, which can make a valuable contribution to returns over the long term. What is more, their simple structure and transparent investment methodology allow investors to calibrate their volatility and return expectations more easily.
But successful ETF investing is not about going to the shelf and simply picking the first one you see. It’s about understanding that each is only as good as the underlying index which it seeks to track. Let’s take a look at the must-have features of an ETF index.
The first question to ask is whether your ETF passes the diversification test. Are its underlying assets sufficiently spread to accurately reflect the index or market you are trying to replicate? If your chosen index is too concentrated, it could mean you fail to participate fully in any upside and, by the same token, it could cause you to suffer more than your fair share of pain in the downside. Investing in an ETF replicating 300 holdings should be no more expensive than investing in one that replicates 30. So why take the risk of leaving yourself under-diversified?
It is also important that your ETF’s underlying securities are liquid. Your expected return could be compromised if you invest in an index containing securities in which it is difficult or expensive to execute trades. Furthermore, if your chosen benchmark is too narrow—which is often the case with thematic and niche indices—you could run the risk of suddenly finding yourself with a materially different, and potentially diluted, portfolio to the one you originally intended to invest in. This is because the asset mix of indices consisting of a concentrated number of smaller, less-tradeable securities can often be skewed by the need to rebalance after large inflows of investor capital, often after a period of strong performance. And when these forced rebalances occur, it is worth remembering that you, as the investor, could be required to bear the additional costs.
The final ‘must-have’ for an ETF is transparency. Having full clarity over an ETF’s underlying holdings is critical when it comes to achieving optimum diversification. But investors also require transparency with regard to methodology. Does the ETF operate under a clear set of rules and have a consistent process for handling index changes?
There are also a number of other best practices that can help an index more accurately reflect the market it seeks to track. For example, adjusting for float—so the index represents the investable opportunity set available in the marketplace—is critical to producing an optimal benchmark, in our view. This is also true of taking a flexible approach to market capitalisation—in order to take into account the relative size of companies.
The success of Vanguard’s ETF range, which is now ten years old, has its foundation not only in the recognition of the importance of these principles but also in the partnering of trusted index providers. Vanguard only works with reliable, globally recognised providers who are aligned with our philosophy and offer only high-quality, objective, rules-based indices.
We also see it as a two-way relationship, with multiple groups at Vanguard contributing to the process. In our view, it is important, for example, that portfolio management and trading teams work closely with index providers to ensure that they have the necessary data to manage the funds effectively and efficiently. We believe that the more high-quality input you provide, the more successful the outcome will be.
The choice and variety of indices in the market is almost overwhelming, while the quality is far from consistent. It is therefore critical that investors first think carefully about what they are seeking from an index and then screen carefully against the three ‘must-have’ criteria.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.
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© 2022 Vanguard Asset Management, Limited. All rights reserved.