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Exchange-traded funds (ETFs) now account for $5.6 tn of assets globally. Much of this growth has been driven by the low fees ETFs offer, especially in comparison to the fees of traditional active managers.
But despite discussion surrounding the importance of ETF fees and the resulting race to zero, Bank of America Merrill Lynch (BofAML) has introduced new, and original, analysis showing that ETF selection should not always be driven by a fund’s expense ratio.
There are other important considerations such as fundamental factors at the stock and sector level as well as technical factors that should be taken into account, notes BofAML. In fact, certain ETF exposures may warrant a higher expense ratio in some circumstances.
To get to this level of understanding, BofAML has leveraged the global breadth of its research capabilities across multiple layers to assess and rate ETFs. This represents a new way of assessing the ETF market. This innovative approach toward ETF analysis aims to uncover underappreciated exposure differentials between ETFs in the same peer group, which can have relative performance implications.
With more than 25 years of investment experience in both research and wealth management, Mary Ann Bartels, head of ETF strategy for BofAML Global Research, is in a good position to lead this initiative.
‘This new methodology produces results that are fascinating,’ Bartels points out. ‘For example, between 2006 and 2017, the average of the median annual difference between the best and worst-performing ETFs within each of the 11 Global Industry Classification Standard sectors was roughly 640 basis points. Our approach is intended to provide investors with the tools necessary to navigate these potential performance differentials in an ETF market that has seen exponential increases in both size and complexity in recent years.’
Liz Everett Krisberg, head of global corporate access at BofAML, also highlights that the value of BofAML’s ETF research is not limited to ETF investors. ‘It’s important for companies to further understand some of the non-fundamental drivers of their stock performance, especially the increasing impact of ETFs,’ she explains. ‘BofAML’s ETF research is a valuable tool that can help IROs comprehend the market dynamics and explain the impact of this significant market force.’
The E, T and F of ETFs Simply put, BofAML’s ETF evaluation process seeks to identify ETFs that may provide some level of alpha over peers, something readers of IR Magazine will also appreciate. BofAML Global Research’s ETF rating system provides guidance by assessing the relative attractiveness of individual ETFs, in part by examining exposures within ETFs as well as the attractiveness of the various categories of ETF.
Each ETF relative to its peer universe under BofAML coverage in the same category is ranked and scored using a proprietary ranking and scoring methodology comprising efficiency, technical and fundamental components, which can be broken down as follows:
– Efficiency: Expense ratio, NAV tracking difference, bid/ask spread and dollar volume are important considerations, as each can impact an ETF’s overall return, but BofAML believes these factors alone provide an incomplete picture of an ETF for investors
– Technical: An assessment of the stock price momentum. BofAML uses the tactical trend model methodology from the BofAML Global Research market and technical analysis team and the Sharpe Ratio. The latter is an important factor for evaluating the price performance versus volatility to understand how efficient the ETF has been at generating those returns. ETFs with higher price momentum and Sharpe Ratios are favored and ranked accordingly
– Fundamental: ETF exposure in relation to BofAML research analyst and strategist views. Differences in portfolio constituent selection and weighting methodologies can create differences in underlying ETF exposures, which are often the largest potential drivers of performance dispersion within a category of ETFs. BofAML identifies these exposure differences and leverages their Global Research franchise to assess them. Given the importance of ETF exposure differentials, BofAML applies a higher weighting to ‘fundamental’ factors than to ‘efficiency’ and ‘technical’ factors in its ETF evaluation process.
For the BofAML Global Research ETF rating system, there is a two-tier system: the first part is the ETF outlook and the second is the category outlook. The ETF outlook indicates BofAML’s view on the attractiveness of the ETF relative to peers in the same category that are also under BofAML coverage. The category outlook indicates the overall macro view on that area of the market to which the ETF provides exposure. Both ETF and category outlooks have 12-month time horizons.
First for ETF analysis All this makes BofAML a thought leader in the field of ETF research. BofAML Global Research was one of the first sell-side research departments to provide investment research on ETFs, a market that currently includes four of the 10 most liquid equity securities in the world. These include the SPDR S&P 500 ETF Trust, the Invesco QQQ Trust ETF and the iShares MSCI Emerging Markets ETF.
BofAML Global Research, led by Candace Browning, was clear in its support of a years-long industry effort to allow broker-dealers’ research departments to begin covering ETFs, which culminated in the enactment of the Fair Access to Investment Research Act 2017. Everett Krisberg sums this up as BofAML feeling ‘strongly it would serve the best interests of our clients.’
Following this, BofAML Global Research launched investment research on ETFs in October 2018. And as the number of ETFs and inflows continue to grow, BofAML is confident clients and corporates will find more and more value in the ETF strategy team’s insights. BofAML’s ratings currently span US equity ETFs in the large-cap, mid-cap, sector and industry segments, breaking down the large and mid-cap segments into peer groups including market cap-weighted funds and non-market-weighted funds, including equal weight, fundamental and multifactor.
According to SEC regulations, for BofAML to cover an ETF it must have been in existence for a minimum of one year and have a minimum of $75 mn in market cap. BofAML requires the funds to primarily provide exposure to the particular area and be well diversified across sub-categories within that area. BofAML’s ETF research is designed to provide investors with a detailed analysis of what makes up the ETF and the potential drivers of performance.
Navigating the ETF market BofAML’s research can provide a framework to assist investors to better navigate the roughly $3.9 tn US ETF market across various investable options to better determine which fund or funds may provide some level of outperformance versus peers.
Investors often overlook the importance of ETF selection on the incorrect assumption that all ETFs within a particular category are too similar to consider anything other than aspects associated with expenses, tracking error and liquidity. Contrary to this perception, BofAML’s work shows that ETF relative performance is significantly impacted by the underlying exposures of the funds, which are, in turn, generally a function of index security selection and constituent weighting methodologies. This is increasingly apparent given the proliferation of ETFs with alternative security selection or weighting methodologies, commonly referred to as smart beta strategies.
Most ETF evaluation strategies in the market today consider a fund’s ability to provide returns in line with its stated goal and its ability to do so in an efficient manner. These considerations can be distilled to tracking errors, expense ratios and liquidity. It should be noted that these are all important considerations.
But BofAML’s research clearly suggests that performance dispersion among ETFs in the same categories is much wider than can be explained by expense ratio, tracking error and liquidity factors alone. BofAML believes it is also much wider than is generally understood by the market.
About Bank of America Merrill Lynch Global Research
Bank of America Merrill Lynch Global Research serves individual investors and a wide variety of institutional money managers, venture capital funds, private equity funds, corporates and governments. In 2018 it connected more than 100,000 investor clients to management teams through conferences, non-deal roadshows, field trips and bespoke events.
