ETFs as benchmarks: is it time?
A topic that continues to gain attention is the massive increases that have occurred with market indexes. We regularly hear stories of firms being required to pay multiples of what they had been for some of the major ones.
Despite the evidence that less expensive equivalents are just as good,* many asset managers and consultants are being required to continue to use both the more popular and more expensive ones.
What alternatives do they have?
Perhaps it’s time to consider exchange traded funds (ETFs). And so,
Why not ETFs as benchmarks?
Is it reasonable to consider, for example, to use an S&P 500 ETF as an alternative to the S&P index? The ETF is, by design, intended to mimic the index. Not only is it perhaps a viable alternative, one might say that it’s a preferred alternative: it’s arguably better than the index itself! Consider the following:**
- ETFs are “investible.” That is, you can invest in them. You technically cannot invest in an index. Recall that being “investible” is considered a beneficial criterion for benchmarks.
- ETFs cover many markets that are represented by indexes, especially the major ones. Thus, they can be used to substitute for many market indexes you’re using.
- They cost nothing! A huge difference with what market indexes cost, especially the major ones.
- They hold real assets.
- Their returns are net of transaction costs.
- Their constituents are available.
I’m particularly intrigued with #5. In fact, I would argue …
Shouldn’t your benchmarks be net of transaction costs?
When you compare your portfolio’s return with a market index you are immediately disadvantaged, because the index’s return has no transaction costs. Does this make for a fair comparison? I would argue “no!”
Comparing your portfolio’s return against an ETF that represents the market provides you more of an “apples-to-apples” comparison, and eliminates the transaction cost issue. Is this not a better test of your investment acumen?
The time has come, the time is now
I’ve noticed a few of our GIPS® verifications clients substituting ETFs for market indexes. Shouldn’t you give it a try? Perhaps start with it alongside the market index you’re paying thousands or tens of thousands of dollars, pounds, or Euros for. We think you’ll find it provides a good or perhaps even better alternative!
What do you think? Please let us know.
Notes:
* See “Are All Market Indexes Created Equal?” Barney, Frances, et al. The Journal of Performance Measurement®. Winter 2015/2016.
** Some of these were offered by João Sousa Dias of BNY Mellon – Eagle Investment Systems at a recent meeting of the Asset Owner Round Table.
The published holdings of the ETF are also available to use when calculating active share, a measure of the percentage of holdings in the composite that differs from the benchmark. Some managers have embraced this concept as a measure of active management and an indicator of potential future excess return.
Excellent point, John! Thanks for your contribution.
David, an ETF will not match the index for reasons other than the transaction costs that are necessary for tracking the index. Will not a fund that sees the index as its proclaimed benchmark but that uses the ETF as an operational benchmark, have to address those other reasons in order to explain to themselves (the fund’s PMs) and the clients of the fund, why when the fund is tracking, to a certain degree, the ETF as their benchmark they are not tracking, to the same degree, the index that is the benchmark of the ETF?
So while it will be cheaper to use the ETF based on an index as a benchmark, it can be less precise (even taking necessary trading costs into account) than using the index itself. At some point, if the index is not affordable, one might just have to forget about that underlying index and decide that it is no longer the benchmark by which one measures success. Instead one will need to face that it is some other instrument with a possibly similar, but not exactly the same, composition as the index that will in fact be the new precise measure of success.
Andre, thanks for your comments.
I have not seen any research as to the accuracy of ETFs in tracking market indexes. I do know that they, like separate account managers, have the burden of transaction costs, which the index doesn’t have.
Will it be “less accurate”? Probably, but will this be material? Some research would help us discover this.
As for rising costs, the problem is that some are forced to use these very expensive indexes. If you’re GIPS compliant, you’re required to show an appropriate benchmark.
Is the ETF appropriate? I suspect an argument can be made that it is.
I wholeheartedly agree at the 110% level. As you note, indexes fail as performance benchmarks, according to the familiar characteristics you cite. The pretense of using their returns as something achievable by investors is perhaps the biggest canard in investment management. The Journal of Indexes quoted a “cheapest to deliver” set of mutual fund indexes for a diversified strategy at about 15 bps. I believe this fee would be a bit higher if using ETFs because of the cost of intraday liquidity (a useless characteristic for a benchmark.) However, “the song remains the same” in that any proper benchmark must represent a passive opportunity cost for investors – meaning net of fees.
Thanks, Steve! Appreciate your input.
I think that index mutual funds could also serve as substitutes, but don’t believe their constituents will be available as easily as an ETF; but, they should be considered, too.
ETFs can have periods of significant tracking error relative to their underlying indexes. This can be meaningful, particularly in less “replicatable” areas of the market like fixed income. But if the ETF itself truly is the benchmark, I guess this is of limited concern.
Jonathan, thanks for your input.
I can fully appreciate the challenge w/fixed income ETFs, especially when trying to align with a market index with several hundred, if not thousand, holdings, which may not always be available or which may have different prices than what’s in the index.
And so, this raises yet another issue to consider. But, if the manager feels that the ETF is technically trying to provide information about the same market, might the huge cost savings make the tracking error easier to handle?
Anyone buying (sorry, licensing) indexes knows how costs have ballooned. And so, looking for viable substitutes is something that needs to be done. Very glad that this post is resulting in a bit of discussion. Thanks!