How do Equity ETFs work and what are they?
“Man is not what he thinks he is; he is what he hides.” ― André Malraux.
Similar is the case with our ETFs. ETFs are not what they seem to be. Several ETFs are named similarly, which is often deceptive to a layman investor.
Investors must evaluate a variety of variables while choosing the right ETF. ETFs’ costs, tracking, structure, and liquidity are all critical. Even with these factors in place, an ETF’s results primarily depend on the underlying assets at the end of the day.
This article aims to help the investor know the nitty-gritty of the ETF nomenclature and why an investor should not go by just the name of the ETF and should also check under the hood.
Let’s take an example and understand why this is the case. Let’s take 2 ETFs tracking the emerging markets:
- iShares Core MSCI Emerging Markets ETF (IEMG)
- iShares MSCI Emerging Markets ETF (EEM).
|Ticker||iShares Core MSCI Emerging Markets ETF (IEMG)||iShares MSCI Emerging Markets ETF (EEM)|
|Average Daily $ Volume||$965.69M||$2.10B|
|Underlying Index||MSCI Emerging Markets Investable Market Index||MSCI Emerging Markets Index|
|Median Tracking Difference (12 Mo)||-0.40%||-1.08%|
|5-year annualized performance||7.24%||6.44%|
The above two funds are very similar, yet they are slightly different and have given separate returns over the same period. The two funds track emerging markets and also follow the same market classification given by MSCI.
Still, they have different tracking indices, which differ very slightly. As seen above, IEMG tracks the MSCI Emerging Markets Investable Market Index, and the EEM tracks the MSCI Emerging Markets Index, which are two different indices with almost the same name!
The case was not very severe in our example; what if the two ETFs tracking very similar markets gave drastically different returns?
Frontier markets made a big impression in 2013, outpacing the BRICs and other developing markets by a wide margin. Frontier markets are developing-world capital markets that are less developed.
Because it is too tiny, has too much inherent risk, or is too illiquid to be termed an emerging market, a frontier market is a country that is more established than least developed countries (LDCs) but yet less established than emerging markets. Pre-emerging markets are another name for frontier markets.
The iShares Frontier 100 ETF (FM) and the Guggenheim Frontier Markets ETF are the two broad frontier market ETFs currently available (FRN).
You’d believe they’re the same fund because they both
claim to have broad exposure to frontier markets.
However, if you had invested in the wrong one, you would have had no idea that frontier markets performed well in 2013. FM returned over 25% in 2013, whereas FRN returned -13 %. That’s a 38 percent difference in returns between the two funds!
FRN uses the BNY Mellon classification system and is only allowed to retain depositary receipts. As a result, the underlying basket gives you access to nations like Chile, Colombia, Egypt, and Peru, which account for more than 70% of FRN’s weighting, even though MSCI, FTSE, and S&P all classify them as emerging.
Meanwhile, FM adheres to MSCI’s classification system and is authorized to hold local securities – this gives FM a preference for Saudis like Kuwait, Qatar, and the United Arab Emirates, as well as African nations like Nigeria and Kenya.
The lesson here is to not assume that a fund will cover a country, sector, location, or theme precisely as you think based on its name. Checking under the hood is the key!