With over 2,400 ETFs available for sale in Europe and the range of products continuing to expand, the challenge for investors and their advisors is how to select the best ETF for their investment objectives. Exchange-traded fund selection is no easy task, but since an ETF is designed to track an index, a good starting point is to understand whether the index that an ETF tracks truly reflects the market exposure that one seeks.
This involves scrutinising the index's construction methodology. The proliferation of ETFs has gone hand in hand with that of indexes, with more and more ETFs tracking new, differentiated, and increasingly complex indexes. This, ultimately, calls for investors to step up their due diligence. Meanwhile, there remain many ETFs in Europe that track the same or very similar indexes. When selecting between these, investors are often tempted to choose the fund with the lowest management fees. Management fees are a major contributor to the total cost of ETF ownership and are therefore a useful—and in most cases readily available—criteria of selection.
However, they certainly don't tell the full story. The least-expensive ETFs are not always the best-performing ones. As illustrated in the table below, over a given period there are examples of ETFs that outperform cheaper rivals tracking the same or a similar benchmark. This may be so for several reasons, including the performance boost from securities-lending revenue or tax-optimisation practices.
The table below serves to illustrate that examining management fees in isolation will not necessarily lead investors to pick the ETF delivering the highest-fidelity tracking performance. And yet, it is difficult to understate the impact of management fees on long-term performance, thus their guiding value in the ETF selection process. Tracking difference, which is the under- or outperformance of a fund relative to its benchmark index, may stand as a more useful metric. It measures the annualised cost of holding a fund and, in addition to the management fees, it factors in the effects of ancillary operations undertaken as part of the fund management process.
However, it isn't a fool-proof measure either, as it is backward-looking, can vary across different time horizons, and cannot account for the impact of future fee cuts or other improvements to the portfolio-management process. Tracking error is another metric used to evaluate ETF performance. It measures the variability of a fund's deviations relative to the benchmark index.
This volatility indicator may be useful for tactical investors who buy and sell frequently, but it has limited use for buy-and-hold strategic investors. On top of essential factors such as the makeup of the fund's benchmark index, fees, and tracking performance, investors may also consider liquidity, the strength of the parent company behind the ETFs, as well as an array of individual preferences for or against specific aspects of the fund-management process.
All these can influence the decision-making process. As such, any assessment should be conducted on a case-by-case basis to suit the specific requirements of the individual investor. Despite these challenges, Morningstar believes that a generic guidance framework for fund selection is not only feasible, but can be of great value to investors with a long-term view. This is why we recently incorporated ETFs into our Analyst Rating framework. The Analyst Rating is designed to help investors home in on the best strategies within a Morningstar Category, which include ETFs as well as other index-tracking funds and actively managed mutual funds.
This is a holistic approach, which, in the context of ETFs, goes beyond the sole analysis of cost and tracking performance. Within this framework, we take a view on which strategies—as defined by the underlying index—are likely to deliver the best outcomes for investors over the long term.
