Exchange Traded Funds (ETFs) have come a long way from their introduction many decades ago. The first ETF was actually launched in Canada in 1990. At that time, these instruments were created for institutional platforms to execute complex trades at a lower cost. As the markets evolved, ETFs went from being a vehicle to gain broad market exposure to what we see today – a vast universe of ETFs that offer exposure to a myriad of asset classes employing different strategies.

This ETF universe has become so big that investors can find it difficult to determine which ETF is best suited for them, especially when two different providers offer seemingly similar exposures. To better navigate ETF offerings, we have listed three areas of consideration below:

Provider: Invest in ETFs that are launched by providers that are credible and established. This ensures that they have the ability and resources to track the performance of the indices they promised to mimic. Also, check with your advisor whether they have strong relationships with an ETF provider which may be drawn upon should operational or liquidity problems arise.

Investment Methodology: Understand how individual positions are added or removed from an ETF.  Some ETFs passively track an index while some use active managers that inject their own research and opinions into portfolio selection. There are also factor-based ETFs that use specific filters to make position selections. These filters could be driven by quantitative factors that rely on trading rules and signals like momentum and meeting earnings targets.  Other filters may use fundamental factors that prioritize valuation, profitability, and dividend metrics. Some filters may not even include financials at all and seek to filter for a company’s environmental impact on society. Ultimately, there is not a consensus in the industry as to how these factors are defined. Hence, ETF providers may differ on what constitutes “high dividend” or “environmentally friendly” or “high momentum”.  Investors should seek to understand how a product defines their factors and whether they agree with the characterization.

Portfolio Constituents: Some products may seem similar by name and methodology, however, the holdings differ widely. It is important to analyze the top holdings, market cap exposure, sector exposure, and geographic breakdown to ensure it meets your expectations.  Investors should also understand how positions are held in the portfolio. This includes how constituents are weighted, the existence of concentration limits, frequency of rebalancing, and currency hedging mandates.

Investment methodology and portfolio composition are one of the main reasons why investors see ETFs that operate in the same space but end up with different performance. Other areas that investors should pay attention to are management fees, tracking errors, liquidity, and taxable distributions. This is by no means an exhaustive list of the criteria used to evaluate an ETF. One should consult their advisor to determine the most suitable ETF for their portfolio. Investing in ETFs may be thought of as a passive approach but determining appropriateness and suitability is anything but passive.