ETF efficiency: How to evaluate an ETF

The homebuilder who constructs sturdy houses that stand for hundreds of years does a better job than one whose homes collapse after a short period.

That’s a clear way to assess how well a homebuilder does their job, but what about ETFs? How do we judge how well an ETF does its job?

In short, by judging its efficiency. An efficient ETF produces maximum results with minimal input.

Expenses

In the case of ETFs, the main input is a fund’s expense ratio—the rate charged by the fund to do its job. Since the job of most ETFs is to track an index, we can assess an ETF’s efficiency by weighing the fee rate the fund charges against how well it “tracks”—or replicates the performance of—its index. ETFs that charge low fees and track their indexes tightly are highly efficient and do their job well.

Tracking difference

One obvious place to start is with fees: the lower the better. But while that’s a good starting place, not all funds with low fees will track their indexes well. As such, it makes sense to focus on a fund’s tracking results. How well did the ETF replicate the performance of its index? When the index increased, did the ETF increase by the same amount?

A favored measure is tracking difference—a statistic that looks at how far an ETF has lagged its benchmark, on average, over a one-year period. Tracking difference incorporates the effects of an entire range of management decisions, from securities lending to optimization decisions. Since the principal task of most ETFs is to track an index, funds that deviate from their index—even for short periods—are less efficient and less well run.

Capital gains distributions

Still, it’s not only about performance. Investors also turn to ETFs for tax reasons. By their very structure, ETFs are built to be tax efficient and, as such, should also be evaluated on their tax efficiency.

We consider the rate of capital gains distributions. This can be measured by taking the average capital gains paid out to shareholders over a recent period divided by NAV at the time. Lower values are better here, as they maximize tax efficiency.

You can also consider the general tax treatment of the fund itself: Equity ETFs are inherently more tax efficient for long-term holders than currency funds, for instance.

Risks

Aside from tracking and taxes, the last factor investors should consider is risks. Is the ETF likely to close? If it’s an exchange-traded note (ETN), does it have counterparty risks that make it unownable? Generally speaking, ETFs are well-structured investments, but it always helps to peek behind the curtain.

In sum

Ultimately, a primary reason ETFs have experienced significant growth—and will likely continue to do so—is because they are highly efficient investment vehicles. Still, this does not mean that all ETFs are equally efficient and, as such, investors ought to assess a fund’s expense ratio, tracking results, and capital gains history when evaluating an ETF.