Along with their explosive growth, however, ETFs evolved in

complexity, structure and usage. Unfortunately for many advisors, their due diligence process vis-a-vis ETFs did not. Too often, they employed the same tools used to evaluate mutual fund and separate account strategies, meaning potentially that they may have been asking the wrong questions.

We believe that financial advisors should establish a customized due diligence process – one that is structured and deliberate in nature. This process should recognize the differences between ETFs and evaluate the potential benefits and risks of each ETF. An advisor’s objective should be to match the philosophy and structure of a given ETF with client needs.

STEP ONE: EXAMINE THE STRUCTURE

Advisors should examine the structure of an individual ETF, such as its investment program, tax consequences, custodial policies and other nuances that could impact its effectiveness.

STEP TWO: UNDERSTAND THE UNDERLYING INDEX

When it comes to choosing an index, advisors should start by asking what it would take to “invest with purpose.”

• Is the investment objective more important than just beating the benchmark?

• Does the index align with the advisor’s investment thesis and the client’s desired outcome?

• Is the index investable, or does it include holdings that cannot be accessed directly?

Advisors should make sure their understanding is clear. The index must be measurable, appropriate and reflective of current investment options. For equities, determine if it has the desired capitalization weighting, return variance, style, country, sector or manager risk. For fixed income, establish whether the strategy delivers the desired asset class exposure, risk and yield. Advisors should also evaluate the potential challenges and the benefits of beta, alternative-weighted or actively managed indexes.

STEP THREE: UNDERSTAND THE INVESTMENT MANAGER

Before selecting an ETF, an advisor should get to know the investment manager – the firm’s professionals, process, philosophy and performance. Firm philosophies on product development, experience and expertise can vary greatly. In reviewing the prospectus, especially for an active strategy, examine the manager’s investment process.

• Can it employ inverse and leverage strategies?

• Can it use derivatives as part of the investment process, and if so, does the manager use them for risk management or to take bets?

• Can the ETF contain swaps by structure?

Additionally, is the ETF created in-kind or with cash? This could have a financial impact on the client’s portfolio.

More broadly speaking, financial advisors should get to know the investment manager by examining the following.

• Depth of investment expertise

• Strategies used to manage tax consequences

• Management of turnover

• Handling of transaction costs

• Tactics used to deal with tracking error

• Use of optimization, replication or representative sampling

• Fiduciary experience

• Philosophy

BE SKEPTICAL

In creating a customized due diligence process, advisors must take care to avoid some of the most common misconceptions. Following are three key considerations.

Explicit Costs

These are the most commonly cited costs in comparative articles or reviews. They include expense ratio, commission and bid/ask spread, all of which are readily identifiable and easy to discuss and understand.

Implicit Costs. Unlike explicit costs that can be researched across many data sources, implicit costs can be harder to quantify. While they may require more effort to unearth, implicit costs are just as important as their explicit counterparts. Implicit costs include

capital gains, turnover within the fund, the funds tracking success against its index (or a standard market benchmark) and distribution or platform fees.

It is important to understand that these costs are not independent of one another; sometimes lowering an explicit cost can increase implicit costs or even reduce the effectiveness of the investment strategy.

Implicit Costs

Unlike explicit costs that can be researched across many data sources, implicit costs can be harder to quantify. While they may require more effort to unearth, implicit costs are just as important as their explicit counterparts. Implicit costs include

capital gains, turnover within the fund, the funds tracking success against its index (or a standard market benchmark) and distribution or platform fees.

It is important to understand that these costs are not independent of one another; sometimes lowering an explicit cost can increase implicit costs or even reduce the effectiveness of the investment strategy.

Opportunity Costs

As the ETF product landscape continues to evolve, interest in alternative index weighting methodologies has grown rapidly, particularly in the last several years. Use of these so-called “nontraditionally weighted” indices offers another

perspective on costs: the opportunity cost — and the choice of

one product over another dictates opportunity cost.

For an in-depth discussion of these three basic categories of ETF purchasing costs, we urge you to review our paper, “The Total Cost

of ETF Ownership, An Important — but Complex — Calculation.”

ONCE PROCESS IS ESTABLISHED, REVIEW ETF INVESTMENTS REGULARLY

In our view, many of the metrics used by financial advisors to evaluate ETFs are obsolete. Rather than assessing ETFs the same way mutual funds are evaluated, advisors should create and implement a customized due diligence process that allows them to match products with what is most appropriate for their clients’ needs and objectives. To do so, they should seek to understand a fund’s construction, methodology and investment philosophy to determine whether it aligns with what they are trying to accomplish. And they should fully understand how to more accurately evaluate the total cost of owning an ETF. We recommend establishing a regular review process to verify that the ETFs in your clients’ portfolios are continuing to meet their needs and have the stability to weather change and uncertainty.

DEFINITIONS

Beta  is a statistical measure of the volatility, or sensitivity, of rates of return on a portfolio or security compared to a market index.