By WestEnd Advisors

If you’ve ever tried to put together a bike for a child’s birthday (or assemble a piece of Dutch flat-pack furniture) then you know: a screwdriver is a screwdriver…until you need a Philips-head and only have a flat-head.  Tools often look similar, but when faced with a particular job, having the right tool can make all the difference.  ETFs are investing tools.  When building a portfolio with ETFs, it may seem a sector ETF is a sector ETF, but look closely and you will find similar-seeming investment tools vary widely.  In particular, differences in underlying exposures and costs among ETFs representing the same sector can impact performance and, thus, desirability in a given market environment.

Fundamental Differences

The Technology sector easily illustrates the question of fundamental exposure.  One of the largest U.S. Technology sector ETFs includes large-cap, S&P 500 companies in various Technology industries as well as in Diversified Telecommunications Services.  Another large U.S. Technology ETF includes a range of large, mid, and small-cap U.S. Information Technology stocks, and does not stray outside of what is generally considered the Tech sector.  As a result of these differences, the former not only has a higher average market capitalization than the latter, but a lower beta (less than 1) versus the S&P 500.  An investor with a negative economic or market outlook might reasonably prefer the higher market cap/lower beta option, while an investor with a positive economic or market outlook may prefer the greater potential economic and market sensitivity afforded by incremental exposure to smaller capitalization Technology stocks.

In this case, both examples are relatively low cost with minimal difference in expense ratios and trading spreads, so an investor’s choice between these two options can center on the differences in fundamental exposure and how those differences align with the investor’s outlook.  In most cases, however, there are also likely to be material differences in cost among ETF options.

Fundamentals versus Costs

Of course, costs such as internal expenses and trading costs are important considerations when selecting an ETF.  How to weigh those considerations may depend on factors such as anticipated holding period.  For example, in a strategic investment with a long expected holding period, an ETF’s ongoing expense ratio may be more impactful to realized returns than one-time trading costs.  In a short-term tactical trade, transaction costs may outweigh the expense ratio.  However, in either case, costs should also be weighed against how well an ETF matches the desired exposure and how impactful that may or may not be.

Suppose an investor is looking for an ETF to provide U.S. Financials sector exposure.  A quick search can easily turn up dozens of potential candidates, but even if the investor screens out ETFs with particularly low liquidity or AUM, and those with esoteric features such as leverage or inverted exposure, a sizable universe with significant variation remains.  For example, each of the 10 largest long-only, unlevered U.S. Financials sector ETFs tracks a different underlying index—some are as narrow as a single industry, like Banks or Insurance, while others provide a broad sector exposure.   Additionally, unlike the Technology example, these Financials sector ETFs differ widely in cost, with expense ratios that range from 10 to 64 basis points per annum.

From a fundamental perspective, if an investor has an outlook for consumer-led economic growth, they may prefer a Financials sector ETF that emphasizes exposures that are relatively sensitive to consumption such as banks or credit card payment processors (which some classify as Financials, but others classify as Information Technology companies).  Alternatively, an investor who anticipates a high risk of recession could opt for a Financials ETF with a large-cap focus and increased diversification across the sector, including material exposure to the relatively less economically-sensitive industries like Insurance.

Related: Capturing the Opportunity of Sector Allocation

Once investors determine their preferred fundamental exposure, they still need to consider the variation in exposures relative to differences in cost.   In the case of selecting among prominent Financials ETFs, simply choosing based on fundamental exposures might lead to half a percentage point or more in extra expenses versus other broad-based exposure options.  Investors whose fundamental preferences lead to one of these more expensive options not only need to consider the probability that their outlook plays out, but, if it does, whether the exposure differences between their fundamental preference and cheaper ETFs are likely to justify the extra cost.  In some cases, choosing a more expensive but well-differentiated ETF to align with a specific outlook may be optimal.  In other cases, choosing a less expensive option may be the preferred course.

Conclusion:

Managing a portfolio of ETFs may seem simpler, to some, than managing a portfolio of individual stocks.  However, ETF selection can have a material impact on an ETF strategist’s results.  We believe ETF investors need to dedicate significant time and resources to understand the options available and how the ETFs they might purchase align with their outlook and strategic objectives.  Trying to assemble a bike with the wrong screwdriver is likely to result in a lot of frustration and sub-optimal results.  When assembling an ETF portfolio to implement your outlook, it is important to make sure you find and use the right tools for the job.

This article was written by WestEnd Advisors, a participant in the ETF Strategist Channel.

Important Disclosures:

WestEnd Advisors is an SEC-registered investment adviser. Registration of an investment adviser does not imply any level of skill or training. The firm is an independent investment management firm, 100% owned by its active principals. WestEnd manages both equity and fixed-income assets for individuals and institutional clients.

The investment processes, research processes, or risk processes shown herein are for informational purposes to demonstrate an overview of the process. Such processes may differ by product, client mandate, or market conditions. Portfolios that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than a portfolio whose investments are more diversified.

This report should not be relied upon as investment advice or recommendations, and is not intended to predict the performance of any investment. The information contained herein is not intended to be an offer to provide investment advisory services. Such an offer may only be made if accompanied by WestEnd Advisors’ SEC Form ADV Part 2. All investments carry a certain degree of risk including the possible loss of principal, and an investment should be made with an understanding of the risks involved with owning a particular security or asset class. Past performance is not indicative of future results. It should not be assumed that recommendations made in the future will be profitable. These opinions may change at any time without prior notice. While every effort has been made to verify the information contained herein, we make no representation as to its accuracy.

The Standard and Poor’s 500® Stock Index includes approximately 500 stocks and is a common measure of the performance of the overall U.S. stock market.  An index is unmanaged and is not available for direct investment.

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