The world of ETFs has grown pretty large and colourful: there are products on standard indices, on trending themes or on so-called factors. Choosing from what are now hundreds of ETFs is correspondingly tricky. It is more convenient to delegate the selection.
The story begins with a flop. When John Bogle, the founder of the investment firm Vanguard, set up his "First Index Investment Trust" tracking the US S&P 500 stock index at the end of 1975 and brought it to market in 1976, the public was less than thrilled. Simply track a broad market index? To Wall Street that seemed all too "average". It correspondingly took a long time, until 1984, before Wells Fargo entered the fray with a similarly designed fund tracking the S&P 500. Today the market is fiercely contested. At the end of June 2021, according to the research firm ETFGI, around 1.4 trillion US dollars was invested in more than 1,800 different ETFs in Europe alone. In the US it was even over six trillion US dollars sitting in around 2,400 ETFs.
Behind the name "exchange traded fund" there now lies a wide variety of very different strategies. These still include the ones in which ETFs track well-known share indices such as the S&P 500 or the DAX. But they also include ETFs on theme indices specially constructed for the purpose - on demographic developments, say, or the "future of nutrition". There are also ETFs on specific factors such as "low volatility" or "value" (intrinsic-value stocks), which also play a role in the quirion portfolios. Even though this is nowhere near an exhaustive list of the variety on offer, one thing becomes clear: the product selection does not take care of itself.
Not all ETFs are created equal
That applies even to products on standard indices. "You might think that ETFs are close to perfect competition," says Kai Hattwich, Senior Portfolio Manager at quirion and Quirin Privatbank. "The same product is available from various providers - so cost alone decides." But in many cases that is not how it is. "With products on the DAX, the differences are admittedly not that big - after all, it contains only 30, and from September then 40, shares." Yet with indices such as the S&P 500 or the MSCI World, with over 1,500 stocks, replication is much more complicated. There can be considerable differences in quality here.
This is where another difference between ETFs often comes into play - the one between physically and synthetically replicating products. "Physically replicating" means nothing more than that the portfolio holds shares that are included in the index. Because "one-to-one" replication is hard to achieve with indices containing especially large numbers of stocks, "sampling" can be used in such cases. The ETF then holds only the stocks that have the greatest influence on the index's performance. With products described as "synthetic", the ETF provider swaps the performance with a financial partner: the partner delivers the index performance and receives the return of a basket of securities that the ETF provider posts as collateral. This way the portfolio can stay manageable, and stocks need to be bought or sold within the fund less frequently. That is considerably cheaper when replicating large indices.
But because the idea of synthetic replication is not so intuitive, the "physical or synthetic" debate unsettles some investors. "You do not need to worry much about the replication method; the risk of the swap arrangement is highly limited," explains ETF specialist Hattwich. There are also studies, he says, showing that in recent years synthetic ETFs on the S&P 500 have in many cases delivered significantly better performance than their physical counterparts. Even so, Hattwich and his colleagues pay attention to the details of such arrangements when selecting ETFs for quirion's world portfolios. "With synthetic products, for example, we take a close look at how the ETF provider collateralises the portfolio and how it manages the risk."
Measuring the accuracy of the replication
At its core, though, for Hattwich the quality assessment comes down to replicating performance as accurately as possible. As far as that goes, indicators such as "tracking error" count, but above all "tracking difference". Tracking difference measures how much the return of an index product deviates from that of its reference index. Tracking error indicates how large the fluctuations are between the individual data points that make up the fund's average tracking difference.
What also counts for Hattwich is the quality of the portfolio management. "Here we pay attention to the fund's market access." If, for example, an emerging-markets ETF is invested in Asia but also in South America, different time zones have to be taken into account when trading. "What matters here is how cheaply and quickly the fund can buy or sell stocks."
A close look at the costs
quirion is meticulous in its selection in other areas too. This applies to costs, for example. A key criterion for quirion is the real costs, which also factor in things like the difference between the fund's and the index's performance - and not the total expense ratio of funds communicated by issuers, which many investors look at. "The total expense ratio is really only one component of the real costs. On average it has an influence of only around 49 percent on the return difference between ETFs."
For Hattwich, a professional ETF selection rests on knowledge of various analytical methods. "On top of that, we use information sources such as specialised databases that are not generally accessible and in some cases quite expensive," the product expert points out. A private investor could of course not put in such a high level of effort in the selection. A professional and independent selection, and portfolios tailored to different risk profiles: for Hattwich, those are good arguments for opting for digital asset managers like quirion. "I think it simply improves your quality of life as an investor not to have to deal with the details."
You can see which ETFs have successfully passed quirion's selection process in this overview.
