ETFs May Not Be What You Bargained For

In a prior blog post, I discussed the performance hurdle that fund costs impose for actively managed strategies, making the case for lower cost solutions. Was this a plug for pure ETF portfolios? Hardly. Yes, ETFs have low direct costs, but there are notable caveats and indirect costs associated with ETF investing.

Pick an ETF, any ETF? The popularity of ETFs was borne out of investor demand for a simple, low-cost way to gain broad exposure to a chosen asset class. But the investor experience can vary widely within seemingly similar ETFs, with a key differentiator being the underlying indexes that the ETFs attempt to track. Suppose an investor has to choose between two US small cap growth ETFs, one that tracks the MSCI US Small Cap Growth Index and the other that tracks the Russell 2000 Growth Index. Despite its apparent randomness, this choice may offer significantly different outcomes, especially over the longer term. Over the 25-year period ending March 2018, the MSCI US Small Cap Growth Index returned an annualized 10.5%, while the Russell 2000 Growth Index returned an annualized 8.1%. The disparity likely stems from differences in index inclusion criteria and how and when indexes are rebalanced (more on this below).

Buy high, sell low. Wait, what? Typically, once or twice per year, index providers re-evaluate the makeup of their indexes, adjusting the weights of constituents, removing the securities that no longer meet the selection criteria, and adding those that do. This index rebalancing, or “reconstitution” as it is termed, can introduce significant liquidity demands, bidding up the prices of securities with high purchase demand (typically additions) and dampening the prices of securities with high sell demand (typically deletions). ETF managers, whose mandates are to track indexes, are essentially forced to “buy high and sell low.” This lack of trading discretion during reconstitution periods is a hidden cost that ETF investors must bear.

Style drift. Depending on market conditions, there may be periods between index reconstitution dates during which the index looks meaningfully less like the asset class it intends to represent. This is known as “style drift.” For the ETF investor, this means experiencing a different performance pattern than he/she had originally expected. Take a value index for example, which is composed of securities with low relative prices (e.g., low price-to-book ratios). Post reconstitution date, any of these value securities may experience a material increase in its price versus the other index members, thereby lowering its return potential. Where’s the “value” in that?

Concentration risk. Following an investment theme through ETFs can result in material concentration risk. Take US growth stocks prior to the dot-com crash in the early millennium for example. As tech stocks became more growth-oriented and escalated in price, their weighting in the Russell 1000 Growth Index surpassed 50%1. Investors in ETFs designed to track this index during this period became highly vulnerable to a downturn in the tech sector (which later followed). Other types of concentration risk may be experienced at the single security and country levels.

Bottom line: Indexes don’t always fully reflect their targeted asset class and there are risks and costs associated with the ETFs that track them. We believe a better way to build low-cost, diversified portfolios is to target proven sources of investment returns across a broad range of asset classes and to rebalance portfolios when necessary.

1 “The Cost of Tracking an Index,” Dimensional Fund Advisors, April 2016.

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