ETP Due Diligence

 

Solid ETP Due Diligence is essential in any investment decision. Developments within the ETP space have made the task of evaluating ETP’s more complex, as products that appear similar at first glance may be quite different upon closer inspection. An evaluation of an ETP’s underlying index is no longer sufficient, as its makeup may deviate significantly from the composition of the index as a result of the portfolio optimization process or replication method. This article provides a brief framework to assist you in evaluating an index and the corresponding ETP.

EVALUATE THE INDEX

Investors should be sure the securities that comprise the benchmark match the exposure they seek. Although there may be a dozen or more indices that cover the same market segment for example, one might track only a small segment of the market while the other may provide broader exposure and therefore hold a greater number of securities. This can result 
in differences in exposure and will almost certainly result in variations in performance between seemingly identical indices.

It is important to consider not only what comprises the index, but the methodology behind its construction. Historically, indices have used market capitalization weighting, meaning that the constituent’s weight in the index is determined by its market capitalization. More recently, proprietary indices have emerged using an assortment of weighting techniques. Equal-weighted or Fundamentally Weighted indices that weight securities based on characteristics such as dividends, revenue or earnings have also been introduced.

Importance of Index Weighting Methodology?

An index’s weighting methodology can lead to inconsistencies in performance and risk/return characteristics among seemingly similar indices. These inconsistencies may be driven in part by the sector weights that define each product. For example, financial companies are generally among the highest paying dividend components of an index. As a result, dividend weighted indexes tend to overweight financials and these discrepancies can be reflected in the ETP’s that are benchmarked to these indexes. These differences in sector weights are important when considering performance from an attribution standpoint.

Another consideration to be mindful of when evaluating an index is the breakdown between growth and value stocks. An index or ETP that is Fundamentally Weighted by dividends may have an inherent bias toward value companies that pay
 a higher dividend. As a result, the performance between a Fundamentally-Weighted index and another index based on Market Capitalization that track the same market segment could vary during a time when growth and value stock performance has deviated.

The same logic used to derive differences in growth; value and sector exposure can be used to help explain why an index’s market capitalization distribution may vary depending on how the index is constructed. For example, in 2008 small cap stocks across the globe were crippled, only to rebound sharply in 2009 as credit and global equity markets stabilized. In markets where the small cap segment is outperforming, it can be expected that an evenly distributed index and corresponding ETP will display parallel movements. However, in years when small cap names are out of favor, an index or ETP with a Large Cap tilt will better withstand the downward pressure.

This is not to say that any one index or weighting methodology is superior to another, but it is critical that investors ensure that the exposure a given index provides, is also aligned with the exposure they seek.

INDEX WEIGHTING SCHEME

DESCRIPTION

MARKET CAPITALIZATION

Stocks are weighted by their representative market capitalization

 

PRICE WEIGHTED

Stocks are weighted by their respective price per share

 

FUNDAMENTALLY WEIGHTED

Respective companies weighted by fundamental characteristics such as dividends, revenue or earnings

 

EQUAL-WEIGHTED

All component stocks receive the same weighting

 

 

THE ETP & INDEX PROVIDER

Evaluation of the ETP provider is a fundamental part of the process. There are a variety of characteristics to look for in an ETP provider:

As the product landscape expands and products become more complex, so too do the investor’s due diligence responsibilities. To accommodate the investor, several ETP providers have dedicated resources to respond to client inquiries and requests for analyses, other Providers don’t respond at all. Many of resources the ETP Providers provide online, while sometimes biased, can be valuable to the investor not only in helping to decipher the difference between similar ETP’s, but also by offering a point of contact for potential questions that may arise.

A company with significant size and scale will more often have the product management capabilities already in place to support the development, management and distribution of an exchange traded product. Sound product development, skillful portfolio management and widespread distribution capabilities provide a strong foundation for a successful ETP Provider.

Portfolio Management expertise has become increasingly important, as more ETP’s are introduced that track indices which are more difficult to replicate. Replicating the risk/return characteristics of an index with thousands of issues takes extraordinary portfolio management skill, particularly in some of the more opaque and illiquid markets.

Product Transparency is essential for performing the Due Diligence and some ETP Providers are better than other to report and structure the information flow to investors. Information about underlying Indexes and methodology is essential, so is the presentation of standardized performance measures like SEC yield or Duration. If the index is replicated using synthetic swap based methodology, who is the main swap counterparty, and what is the swap collateral composed of etc. On the other hand if the Provider engage in physical replication and security lending, how much of the proceeds from such goes to the investors.

In terms of the underlying Index, it is important investors get detailed transparency into holdings, so as to evaluate sector tilts. How the index select, weight and review/rebalance the index constituents. Above information is really important, but unfortunately also one of the places where compliance vary widely. Never invest in a product you fundamentally don’t know how is constructed.

UNDERSTAND THE REPLICATION METHOD

There are several different investment techniques used by ETP’s. The most common are: full replication through the purchase of physical securities; optimization-based replication through the purchase of physical securities; and synthetic replication through the implementation of total return swaps.

lfull replication approach using physical securities involves the manager purchasing all securities in the same weight as the underlying index. Over time, the manager then tracks changes in the index and manages cash flow from dividends. This strategy will therefore likely provide very close tracking with the underlying index.

l optimization-based replication through the purchase of physical securities involves the manager using an optimization process to create a sampling of stocks from the underlying index that will closely track the performance of the index. The rationale for doing this is to control trading costs and promote liquidity, but such a structure might introduce a higher level of tracking error.

l synthetic replication method is implemented through the purchase of total return swaps, where the provider enters
into an agreement with one or more investment banks or counterparties. The counterparty agrees to deliver the return of the underlying index, sometimes minus a small spread, in exchange for the performance of a pool of securities that is held by the ETP. Should the counterparty default, this collateral pool provides safety for investors in the ETP. To minimize the risks, some synthetic providers over-collaterise the swap and/ or use multiple swap counterparties. A synthetic based ETP should track the underlying index closely, but it does not physically hold the index’s component shares. The swap structure does introduce credit risk and can reduce transparency.

There are benefits and risks to each approach; ultimately, investors need to decide what is most appropriate for their investment needs.

CONSIDER TOTAL COSTS

The expense ratio is not the only cost associated with
 ETP’s. Commissions and transaction costs apply when buying ETP shares in the secondary market. ETP shares trade throughout the day like any other stock on major exchanges. As a result, any commissions would be absorbed by the investor purchasing or selling shares. 
 The fund’s expense ratio and expected commission payments are costs that can be accurately forecasted. However, there are a number of less transparent costs that may arise from ETP transactions.

BID/OFFER SPREAD AND LIQUIDITY

The nature of exchange-traded funds can lead to implicit costs of investing. The primary implicit costs are trading costs and tracking error. Aside from commissions, the most obvious trading cost is the bid/offer spread. While some ETP’s trade at spreads within a few cents, other thinly traded ETP’s may widen out. ETP bid/offer spreads are readily available through a variety of third party data sources or exchange websites. Since ETP’s are open-ended vehicles in which new shares can be created and existing shares redeemed by designated Authorized Participants (APs), it is also important to look at the underlying liquidity of an ETP’s constituents when evaluating execution cost. It should also be noted that much of the ETP trading takes place in the over-the-counter (OTC) market, so the true bid/ offer spread and overall liquidity of an ETP can be more difficult to ascertain. ETP sponsors should have an accessible Capital Markets team to help institutional investors navigate through the intricacies of trading their ETP’s.

PREMIUM/DISCOUNT TO NAV

An ETP’s premium or discount is another element that should be considered in a thorough evaluation. The market price for
an ETP reflects market supply and demand for an underlying product while the Intraday Indicative Value (IIV) or Intraday Optimized Portfolio Value (IOPV) is a signal of the underlying value of the securities in the fund. The creation/redemption mechanism is responsible for keeping the market price of the fund in line with the IOPV. For example, if an ETP’s market price was trading at a significant premium to the indicative value, an arbitrage opportunity may exist for the Authorized Participant. The AP might be enticed to create more shares and capitalize on the difference. The existence of more shares in the market should cause the market price to come back into formation with the IOPV. However, in markets where pricing of the underlying securities in an ETP are dislocated, or illiquidity limits an AP’s ability to hedge its position, it can be expected that the ETP’s market price may drift further from the IOPV.

In extreme cases, certain events can trigger a spike in trading 
of ETP shares which can cause the fund to trade at a premium
or discount, depending on the news. For example, if a natural disaster were to take place in China, demand for ETP shares based on Chinese equity markets could plummet, sending share prices to a steep discount to the IOPV. In these situations, the largest and most heavily traded ETP’s tend to trade at the sharpest discounts, as investors flee a particular market. In this example, it might make sense to look for an ETP tracking the same asset class whose share price more closely represents the intraday indicative value. In any case, it is always prudent to analyze the market quality of an exchange traded product and to potentially control trading risk by using tools like limit orders when investing.

TRACKING ERROR

Tracking error is another important indicator of a fund’s overall quality. Investors using ETP’s are looking for cost effective beta exposure to a desired market segment. Excessive tracking error can negate this fundamental purpose of ETP investing. Tracking error has many definitions, although the simplest is defined as the difference between a fund’s NAV performance and the total return of the underlying index. It is important to note that it is the fund’s NAV performance that should be considered, as opposed to the market price performance of the ETP. An investor’s cost basis for a share purchase is driven by supply and demand and cannot be used as an accurate assessment of how well a fund tracks its index. Depending on an investor’s time horizon, tracking error can be measured daily, monthly, quarterly or annually. For example, an investor actively trading ETP’s would be more concerned with how an ETP tracks on a daily basis, whereas a long-term investor might only monitor a fund’s tracking on a yearly basis. In either case, funds with tighter tracking should have a competitive advantage.

ETP’s that are fully replicated tend to exhibit low tracking error. However, ETP expansion has been propelled by growth in products offering access to more non-traditional markets
that tend to be heavily optimized. ETP’s that are more heavily optimized or sampled have a greater likelihood of exhibiting wider tracking error. In order to efficiently optimize a fund, the fund provider’s portfolio management history and skill play an important role. In general, an investment manager with a history of indexing strategies and the foundations in place to support ETP growth should have success transferring those skills to ETP management.

CONCLUSION

The dynamics of the ETP landscape continue to evolve. Moving in lockstep with this evolution is the growing complexity of ETP analysis, as ETP’s that appear to represent the same market segment can sometimes look markedly different beneath the veil in terms of index methodology and product construction.

Ultimately, investors need to look beyond simply the exposure of the underlying index when evaluating an ETP. Assessing index methodology, replication method and overall cost is important in order to best determine whether the ETP fits the desired risk/return profile and investment objective of the investor. And perhaps most important is considering an ETP provider with a strong indexing history, deep portfolio management expertise and dedicated client service and support to help investors evaluate their options.