Due diligence framework needed for selecting index ETFs

Prerna Chandak, Mackenzie Investments

Prerna Chandak, pictured, Vice President ETFs at Canada’s Mackenzie Investments, has published a white paper on index investing, finding that advisers and investors should consider a due diligence framework for selecting index ETFs, ideally one that includes four key components: assessing index exposure, product structure, total cost of ownership and support offered by the ETF provider.

Index investment has long been favoured by investors for its rules-based approach that offers some level of predictability. It is an investment route for those not looking to time markets or to seek active management expertise to outperform certain markets. It comes with some level of certainty on movement of exposures over time through set rebalancing methodologies. This approach is typically associated with low management fees. Index investment also serves as an important foundation in portfolio construction.

In times of significant volatility as we saw in 2020, ETFs effectively became reliant price discovery vehicles. The significant volatility also highlighted that index investing too can require some level of active decision-making within the index ETF and the index it tracks. Some examples of such active decision-making can be seen in:

• Postponement of rebalancing schedules (which affected many equities and fixed income indices in the first half of 2020).

• Proposed changes to index methodologies to better address liquidity and offer flexibility to those tracking that index (this affected many oil futures and fixed income indices).

• ETF providers sampling within an ETF to better manage for short-term liquidity needs. 
Much of this type of active decision-making is already contemplated in ETF prospectuses and in index methodologies. This begs a broader question on how different index ETFs within a category are constructed and what they may or may not be permitted to do. With over 1000 ETFs listed in Canada and over 2,000 listed in the US, how do you pick which index ETF to use? Will all index ETFs within a category, (for example, US high yield), always act and perform the same way? Inception date, assets under management, management fees and ETF provider familiarity are all common criteria used by investors to choose index ETFs, but all index ETFs are not built alike.
 

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