How we pick our ETFs

Exchange-traded funds (ETFs) can be tricky to analyse because of the multiple aspects investors need to be aware of. Traditional measurements of active fund manager performance simply do not carry across to ETFs – there are marked differences in how the two need to be assessed. This is because of differences in their objectives, legal structures and the way in which they are bought and sold.

At Nutmeg, we assess the performance of ETFs using both quantitative and qualitative measures – but what does that mean?

Understanding exposure

The most important thing for us is to understand the specific exposure that the fund is giving us and how this fits with what we want to achieve. Understanding the index composition and the risk this presents relative to other indices or investments is critical – sector, country and company weights can vary dramatically from one ETF to another.

This can have a significant effect on performance, as this chart of three indices behind major UK equity income ETFs shows.

Source: Macrobond, 28th July 2017

We also want to understand how the exposure is being achieved and what risks this presents – are the ETFs physically buying the underlying securities? Do they hold all the securities in the benchmark or just a selection? How is the manager running the fund?

ETF performance

Next, we study performance. We look at how well the ETF itself has performed relative to its benchmark and peers by looking at certain factors.

First, the tracking difference, or the difference in performance between fund and benchmark. We also consider something called tracking error, which is the volatility of this difference in performance, and the consistency of these measures over different time periods and market environments.

Getting to grips with fees

We think management fees should be taken into account only in the context of the tracking difference of the fund, in order to work out what the fund is actually delivering to investors after fees versus alternatives. Too many investors simply choose the cheapest product, without understanding how poor tracking performance can eliminate the cost advantage.

Other critical areas are trading costs and liquidity. We don’t believe you can simply look at the size of an ETF to determine how easily it can be bought and sold. Instead, we seek to understand the depth of the market in the underlying securities, the costs of transacting and the best way in which to trade.

Analysis by our expert team

Our in-house trading team has built strong relationships with major financial institutions, who are able to provide us with real-time analysis of costs and liquidity. This helps in understanding additional trends – for example, the level of outflows to a rival fund. By considering both the performance and transaction costs, we can determine the total cost of owning the fund in our customers’ portfolios.

From here, we go one step further with a qualitative assessment to understand the processes behind the fund management. How and where are the funds being managed, and by whom? What are the systems and risk management processes being used? Who is responsible for custody and administration of the fund?

To ensure we’re comfortable with how the ETF is being managed, we spend time analysing the investment restrictions and techniques outlined in the legal prospectus. We’ll seek to identify risks in the management process, and assess other factors that could affect performance, for example, something as simple as tax treatment could allow an ETF to outperform the market. The goal of this is to ensure we are entirely confident the ETF provider is adequately positioned to continue to deliver performance, in a prudent and efficient way.

Where we believe our clients can benefit from lower fees or stronger performance, we’ll move their investments to the better fund. This entire process is all included, at no extra charge, for all our customers as part of their fully managed portfolio.

Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.