Investing in ETFs: Are You Really Making A Passive Choice?

Posted on September 19, 2019 by Gemmer Asset

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We’ve written in the past on how making assumptions in ETF investing can lead to some interesting surprises (see here and here). There are such a huge number of ETFs available to U.S. investors that its easy to get overwhelmed when trying do decide where to invest your money.



The chart above shows that of the roughly 2,400 ETFs available in the U.S., nearly half (46%) are less than 5 years old! With all these choices, it has become more important than ever to look under the hood and figure out what type of exposure you’re truly getting when you purchase an ETF. Let’s take emerging markets as an example. In this asset class alone, there are 86 choices… 86 ETFs that mention Emerging Market Stocks as being their primary geographic focus! And this number doesn’t include funds that focus on a specific emerging market country (i.e. China) or use leverage to do things like multiply returns.


You may assume that investing in any one of these funds would yield similar return results but in fact, the range of returns is massive.



Year-to-date, the range of total return for these 86 choices goes from -1.23% to +24.15%!


Where did the mainstream index fall in this return range? Even this question doesn’t have a simple answer! Emerging markets have two widely followed indexes, MSCI and FTSE. A comparison of their country weightings can be seen below.



Over 12% of the MSCI Index just isn’t included in the FTSE index (FTSE considers South Korea a “Developed” nation). How much difference can this really make? Here is a chart of the two ETFs’ YTD total return.



A difference of 2.8%! So even if you manage to sift through the 86 options and find two of the main indexes, your choice still matters.


Not all ETFs are passive


So why does an asset class like emerging markets have so many choices? It really boils down to the massive flow of assets into the “passive” ETF universe.



This flood of dollars into ETFs has caused companies to create their own custom indexes so they can claim a unique strategy and grab a piece of this ever-growing pie. You can’t have a differentiated strategy if your ETF tries to track the main index as closely as possible – that ship has sailed. The more asset class tilts an ETF has, the more “unique” it seems. Take something like the Legg Mason Emerging Markets Low Volatility High Dividend ETF (LVHE) as an example. LVHE created it’s own benchmark to track – appropriately named the “QS Emerging Markets Low Volatility High Dividend Hedged Index.” Is this fund a fair, accurate and passive representation of emerging market equities? No, and I’m sure the people at Legg Mason wouldn’t claim it is. The point is that investors will assume that because the strategy is expressed in the form of an ETF, it’s passive in nature. That couldn’t be further from the truth. These types of choices are only passive in that they track an index, but that index may differ wildly from the actual makeup of the asset class. See below.



Relative to the index, LVHE has nearly 20% less China exposure, 10% more in Thailand, 8% more in Malaysia, etc… These differences add up and lead to large tracking error – and that is ok, if you’re aware of what those differences mean for performance.


More choice is a good thing, right?


Ordinarily, more choice is a good thing. More entrants into the ETF space has led to things like fee compression and access to new parts of the global markets – both good things. But making a choice in this type of universe can lead to two big mistakes. It’s like taking my two young daughters to the toy store. I’ll say “here’s $5, you can pick whatever you want as long as it doesn’t cost more than that.” My older daughter always gets a case of paralysis by analysis, going over each of the hundreds of choices before ultimately giving up for fear of not picking the “best” toy. My younger daughter on the other hand shoots from the hip and picks the first interesting looking thing that crosses her eyes. When we get back home, she usually says something like “Dad, I think I should have picked the other unicorn.”


Investors can make similar mistakes when faced with a lot of options. They either pick an inappropriate investment vehicle because they didn’t do much due diligence, or they throw up their hands and just hold cash for fear of making the wrong choice. If you’ve ever been to Costco, you have experienced the latter principle in action. In this CNBC article, a marketing consultant for Costco describes the company’s reasoning for limiting a shopper’s choice:


“One ketchup, one bottle, one package, one choice… Making people decide, that causes confusion, and they ultimately decide to walk away.”


Get the big things right


So, what’s the right approach for a passive investment in an asset class with a zillion options? After all, we just used emerging markets as an example. Add in all the other major asset classes and things can get overwhelming real quick. There are a few things however, that if done will at least minimize the chances of making a material error:


  • Index: Find the index that most accurately reflects the asset class you’re trying to invest in. If the asset class is International Developed equities, it probably doesn’t make sense to use an index or an ETF that tracks an index composed of stocks that include US or emerging market companies.


  • Tracking Error: Once you’ve nailed down the appropriate index, take a look at the ETFs that have that index as their benchmark. Do they track it closely over both short and long-term periods?


  • Fees: If the tracking error between two choices is very similar and the allocations are close to that of the appropriate benchmark, pick the one with a lower expense ratio. As an example, iShares has two emerging market ETFs that have the MSCI Emerging Market Index as their benchmark: EEM and IEMG. One has “Core” in the name and the other doesn’t. There is a slight difference in country weighting, but nothing huge. Tracking error has been very similar. The only main difference? Fees – one has an expense ratio of 0.14%, the other 0.67%!


There are obviously a bunch of other things to consider but following the above guidelines will improve your chances of being way off base in your allocation decisions.


The term “passive” is used very loosely these days. In reality, if you’re investment portfolio at any given time looks materially different than the global markets, you’re making an active bet.





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