When choosing an ETF to buy for a portfolio, it is important to look not only at the methodology of the fund but also at the team behind it.
By J. Garrett Stevens
It is said that imitation is the sincerest form of flattery, and in the ETF world there is plenty of imitation. You can be certain whenever a new successful ETF is launched that a new version will soon follow.
This epidemic of imitation is rampant on Wall Street, with firms releasing imitations that typically have a new feature or gimmick or are just a straight copy of an original, something attempting to capitalize on another firm’s success. While competition can be good for investors by driving down costs and/or providing more choice, it sometimes results in more confusion, and many advisors simply default to using the fund with the most effective marketing strategy.
The Team
When choosing an ETF to buy for a portfolio, it is important to look not only at the methodology of the fund but also at the team behind it. While it is tempting to just select the fund that has the brand name behind it, the most assets, the longest trading history or the lowest expense ratio, it may not necessarily be the best designed.
At Exchange Traded Concepts, we tend to work with teams who bring expertise in the field and want to launch a fund. These tend to be people who have developed expertise by being intensely focused on a specific sector or theme. In some cases, they might be a research organization looking for a way to monetize their research and who feel the current ETF marketplace lacks this particular type of product.
The importance of the expert approach is just as valid in index-based products as it is in actively managed funds. The design of the index parameters will ultimately determine the fund composition as new securities are added or removed. Experts are better positioned to understand the drivers for companies that are growing or expanding into a particular theme. Equally important to security selection is the weighting methodology. The weighting of individual securities inside the index and fund will have a drastic impact on performance, volatility, and exposure.
Names Rule
Fund names are regulated by the SEC under rule 35d-1, also known as the “Names Rule.” The easiest way to think about this rule is that 80% of the holdings of a fund must derive more than 50% of their revenue from the industry or theme specified in the name of the fund.
The most recent example of the SEC enforcing this rule on the ETF community is the current handful of ETFs that invest in the blockchain theme. Because of the limited number of publicly traded companies that make most of their revenue directly from blockchain, the SEC contacted all the firms that had new funds on file in this space and forbade them from using blockchain in the funds’ names. This led to some rather creative fund names: Innovation Shares NextGen Protocol ETF (KOIN); Amplify Transformational Data Sharing ETF (BLOK); Reality Shares Nasdaq NexGen Economy ETF (BLCN) and First Trust Indxx Innovative Transaction & Process ETF (LEGR).
While the SEC is well intentioned in its defense of shareholders, the unintended consequence can be that these fund names become very complex and may not describe the fund clearly as the issuers struggle to convey the funds’ intended exposure while complying with the Names Rule.
Fund Websites
Before choosing an ETF to provide specific exposure for a client’s portfolio, spend a few minutes on the fund’s website. Read the offering documents to learn about the creation of the fund and the team behind it, and make sure you understand the exact exposure the product provides regardless of its name. While a fund’s expense ratio is important and many investors see a higher AUM number as validation for a fund, there may be a less obvious but better option out there.
If you'd like to see the types of ETFs that ETC advises and sub-advises, click here to view our funds.
Important Disclosures
Exchange Traded Concepts is an SEC Registered Investment Adviser. The Firm's Form ADV is publicly available and can be found here: https://www.adviserinfo.sec.gov/Firm/151197. ETC may be subject to various conflicts of interest in the provision of its services. Potential conflicts of interest shall be identified in the Firm's Form ADV. The Exchange Traded Funds are referred to as "Funds" for purposes of this document. ETC transacts business in the United States and other jurisdictions where it is properly registered or excluded or exempted from registration requirements. This document does not constitute an offer of services in jurisdictions where ETC does not have the necessary licenses.
No representation is made that any Fund's investment process, objectives, goals or risk management techniques will or are likely to be achieved or be successful or that any Fund or any underlying investment will make any profit or will not sustain losses. The risks of investing in a Fund will not be negated by ETC's Fund services, and no assurance is given that a Fund will not be exposed to risks of significant trading losses.
The information provided herein does not constitute tax, legal or accounting advice. ETC does not provide legal, financial, accounting or tax advice. Clients and prospective Clients, as well as investors and prospective investors in a Fund ("Investors") are advised to seek the counsel of their own legal, financial and tax advisors for all matters relating to the services and structures contemplated herein. Each Investor (either alone or with its professional advisors) is solely responsible for its own due diligence, risk assessment and tolerance, investment objectives, any decision to invest in a Fund, and for monitoring its investment for purposes of determining whether it wishes to remain invested in such product and whether such product continues to be appropriate for its circumstances and requirements.
The information provided herein: (a) is provided as of the date indicated, (b) is in summary only and is not complete, and (c) is subject to change at any time without notice. Certain information provided by ETC is based on third-party sources and, although generally believed to be reliable, has not been independently verified. ETC is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness, or timeliness of such information, and ETC assumes no obligation to update or otherwise revise such information. In no event will ETC be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with the use of the information contained herein, even if advised of the possibility of such damages. ETC and its respective employees and its affiliates hereby exclude, to the extent permitted by applicable law, all liability in connection with the use of the information herein.
Interests in Funds will not be insured by the FDIC, the SIPC or any other organization, will not be deposits of any bank, and are not guaranteed by any bank.