Are ETFs A Better Benchmark?

Using Exchange-Traded Funds (ETFs) as benchmarks instead of traditional indices has become a common practice among investors and fund managers. ETFs offer practical advantages, such as reflecting real-world trading costs, and incorporating management fees and tax considerations. These aspects make ETFs a more accurate and accessible benchmark as they are an actual investible alternative to the strategy being assessed.

However, this approach is not without its drawbacks. Understanding both the advantages and disadvantages of using ETFs as benchmarks is crucial for making informed investment decisions and ensuring accurate performance comparisons.

This article discusses the pros and cons of using an ETF as a benchmark and considerations for making an informed decision on how to go about selecting one that is meaningful.

The Advantages:

Using an ETF as a benchmark rather than the underlying index has several advantages. These include:

Cost:

The decision to use an ETF rather than an actual index as a benchmark often stems from the costs associated with using index performance data. While index providers typically charge licensing fees for access to their indices, these fees can be cost-prohibitive for some firms, especially smaller ones, or those with limited resources.

ETFs offer a more accessible and cost-effective alternative, as they provide readily available, real-time performance data and can be traded easily on stock exchanges and accessed by anyone. By using an ETF as a benchmark, firms can circumvent the barriers to entry associated with marketing index performance directly, allowing them to still compare performance against a relevant benchmark.

Practical Investment Comparison:

ETFs represent actual investment vehicles that investors can buy and sell, thus providing a more practical and realistic performance comparison. Indices, on the other hand, are theoretical constructs that do not account for real-world trading costs, whereas ETFs do. Additionally, ETFs are traded on stock exchanges and can be bought and sold throughout the trading day at market prices, unlike indices which cannot be directly traded.

Incorporation of Costs:

ETFs include trading and management expenses and other costs associated with managing the pool of securities. When using an ETF as a benchmark, you get a more accurate reflection of the net returns an investor would actually receive after these costs. In addition, ETF performance considers the costs of buying and selling the underlying assets, including bid-ask spreads and any market impact, which indices do not.

Dividend Reinvestment:

ETFs may account for the reinvestment of dividends, providing a more accurate measure of total return. Indices often do not factor in the practical aspects of dividend reinvestment, such as timing delays, transaction costs, and tax implications, leading to a potentially less realistic depiction of investment returns.

Tax Considerations:

ETFs may have different tax treatments and efficiencies compared to the theoretical index performance. Using an ETF as a benchmark will reflect these considerations, providing a potentially more relevant comparison for taxable investors.

Replication and Tracking Error:

ETFs can exhibit tracking error, which is the deviation of the ETF’s performance from the index it seeks to replicate. While tracking error may be perceived as a limitation, it also reflects the real-world challenges and frictions involved in managing an investment portfolio. Thus, using an ETF as a benchmark encompasses this aspect of real-world performance—which acknowledges the practical complexities of investing and serves to enhance transparency and accountability in investment decision making.

Transparency and Real-time Data:

ETFs provide real-time pricing information throughout trading hours, allowing investors to monitor and compare performance continuously as market conditions fluctuate. This real-time data enables more informed and timely decision-making, as investors can react instantly to market events, manage risks more effectively, and capitalize on opportunities as they arise.

Advantages Summary

In summary, using an ETF as a benchmark provides a less-costly, more realistic, practical, and accurate measure of investment performance that includes real-world considerations like costs, liquidity, tax implications, and dividend reinvestment, which are not fully captured by indices. ETFs are a true investable alternative, while indexes are not directly investible.

The Disadvantages:

While using an ETF as a benchmark has several advantages, there are also some potential drawbacks to consider:

Downside of Tracking Error:

ETFs may not perfectly track their underlying indices due to various factors such as imperfect replication methods, sampling techniques, and management decisions. This tracking error can result from differences in timing, costs, and portfolio composition between the ETF and its benchmark index.

This deviation can lead to discrepancies when comparing the ETF’s performance to the actual index and can affect investors’ expectations, portfolio management decisions, and performance evaluations. Thus, it is prudent to evaluate and monitor tracking error of ETFs when they are used as a benchmark.

Tracking Method: Full Replication vs. Sampling

ETFs employ different replication strategies to track their underlying indices, with some opting for full replication, while others utilize sampling techniques. These differences can lead to varying levels of tracking error and performance differences from the underlying index.

Full replication involves holding all of the securities in the index in the same proportions as they are weighted in the index, aiming to closely mirror its performance. In contrast, sampling techniques involve holding a representative subset of securities that capture the overall characteristics of the index.

While full replication theoretically offers the closest tracking to the index, it can be more costly and logistically challenging, especially for indices with a large number of securities. Sampling, while potentially more cost-effective and manageable, introduces the risk of tracking error, as the subset of securities may not perfectly reflect the index’s performance.

Non-Comparable Expense Ratios:

ETFs incur management fees, which reduce returns over time. While these fees are part of the real-world costs, they can make the ETF’s performance look worse compared to the theoretical performance of the index, especially when compounded over time. This may be problematic when using an ETF as a comparison tool (think expense ratios dragging down ETF benchmark performance thus making the strategy appear to have performed better than it would have against the actual index). This has the potential to influence investment decisions and performance evaluations. To address this concern, the GIPS Standards now require firms that use an ETF as a benchmark to disclose the ETF’s expense ratio.

Many active managers might argue that it’s “unfair” that the SEC requires them to compare net returns against an index that has no fees or expenses. However, if the strategy’s goal is to beat the index with active management, the manager should be doing this even after fees, otherwise passive investing (with lower fees) is a better option.

Liquidity Constraints:

Some ETFs may suffer from lower liquidity, leading to wider bid-ask spreads and higher trading costs, especially for large transactions. This can affect the ETF’s performance and make it less ideal as a benchmark.

Selection Dilemma

Multiple ETFs may track the same index, each with different structures, expense ratios, and tracking accuracy (e.g., check out the differences between SPY, IVV, VOO, SPLG). As a result, choosing the most appropriate ETF as a benchmark should involve consideration of factors such as cost-effectiveness, liquidity, tracking error, and the strategy’s specific investment objectives. As a result, some due diligence should be done to ensure that the selected ETF aligns closely with the desired index and makes sense for the investment strategy.

Some firms have made it a habit to mix the use of different ETFs in factsheets, often because their data sources lack all the data needed for one ETF. While it may seem like it’s all the same, for many of the reasons discussed in this post, not all ETFs are created equal. We do not recommend mixing benchmarks, even when using actual indices (e.g., comparing performance returns to the Russell 1000 Growth, but then showing other statistics like sectors compared to the S&P 500). Similarly, we wouldn’t recommend doing that with ETFs either (e.g., comparing performance returns to IVV but using sector information from SPY). Mixing benchmark information in factsheets is messy and likely to be questioned by regulators, especially when doing so makes strategy performance look better.

Regulatory and Structural Issues:

ETFs are subject to evolving regulatory oversight that might affect their operations, costs and performance as benchmarks. This is not the case for indices.

In addition, the structural differences between ETFs, particularly regarding whether they are physically backed or use synthetic replication through derivatives, can significantly impact their risk profile and performance relative to their underlying indices.

Physically backed ETFs typically hold the actual securities that comprise the index they track, aiming to replicate its performance as closely as possible. In contrast, synthetic ETFs use derivatives, such as swaps, to replicate the index’s returns without owning the underlying assets directly. While synthetic replication can offer cost and operational advantages, it also introduces counterparty risk, as the ETF relies on the financial stability of the swap provider.

As a result, it’s best to consider the structure of the ETF before using it as a benchmark.

Market Influences:

ETFs can trade at prices above (premium) or below (discount) their net asset value (NAV), which can introduce short-term performance differences that are not reflective of the underlying index performance.

These premiums and discounts arise due to supply and demand dynamics in the market, as well as factors such as investor sentiment, liquidity, and trading volume. These fluctuations can affect the ETF’s reported returns and introduce discrepancies when comparing its performance to the benchmark index. Therefore, investors must consider the impact of these premiums and discounts on the ETF’s short-term performance and recognize that these variances may not accurately represent the true performance of the underlying index.

When material differences in price vs. NAV exist, some firms believe that the NAV is a better representation of the fair value rather than the price and have used NAV for performance calculations. Please note that when this is done, it is important to document how fair value is determined and if the performance is based on the change in NAV or change in trading price.

Currency Risk:

Investors utilizing ETFs tracking international indices face the added complexity of currency fluctuations, which can significantly influence the ETF’s performance. When investing in foreign ETFs, investors are exposed to currency risk, as fluctuations in exchange rates between the ETF’s base currency and the currencies of the underlying index’s constituents can impact returns. Currency movements can either enhance or detract from the ETF’s performance, depending on whether the base currency strengthens or weakens relative to the underlying currencies.

Consequently, currency risk should be considered when using international ETFs as benchmarks.

Dividend Handling:

The handling of dividends by ETFs, whether they are paid out to investors or reinvested back into the fund, can have a notable impact on their total return compared to the index they track. Indices typically assume continuous reinvestment of dividends without considering real-world frictions such as transaction costs or timing delays associated with reinvestment. In contrast, ETFs may adopt different dividend distribution policies based on investor preferences and fund objectives.

ETFs that reinvest dividends back into the fund can potentially enhance their total return over time by capitalizing on the power of compounding. However, this approach may result in tracking errors if the reinvestment process incurs costs or timing discrepancies that deviate from the index’s assumed reinvestment.

ETFs that distribute dividends to investors as cash payments may offer more immediate income but could lag behind the index’s total return if investors do not reinvest these dividends efficiently. Therefore, the dividend handling policy adopted by an ETF can significantly influence its performance relative to the index and should be carefully considered.

Lack of Historical Data:

Some ETFs, especially newer ones, may not have a long track record. This can make historical performance comparisons less reliable or comprehensive. Without an extensive performance history, sufficient data may be lacking to assess an ETF’s performance across various market conditions and economic cycles, making it challenging to gauge its potential risks and returns accurately.

Strategies that existed long before an ETF was created to track the comparable index, may end up with timing differences. Many firms often need to use multiple benchmarks to cover the entire period. But, for some strategies that go way back, an ETF may not exist back to inception. Be sure to include rationale in your documentation for benchmark selection so that it is clear when and why a benchmark was selected for the given time periods.

Conclusion:

In conclusion, using ETFs as benchmarks offers practical benefits, potentially making them a more accurate and accessible measure of investment performance compared to traditional indices since they are an actual investable alternative to hiring an active manager. However, these benefits do not come without shortcomings. By carefully evaluating these factors and considering the specifics of the ETFs selected for each strategy, managers can effectively use ETFs as benchmarks to assess and monitor investment strategies. In understanding these factors, an ETF may actually be a better comparison tool for your strategy than the underlying index.