Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 178

Improving ETF selection based on principles and data

Exchange Traded Funds (ETFs) increasingly come in different shapes and sizes and offer efficient access to more asset classes and sectors than ever before. Growth has been rapid. Of the 150 Exchange Traded Products on the ASX, 80 have been listed since 1 January 2013. This is good news, because they usually bring access at a reduced cost compared to other investment vehicles. ETFs now play an important role in investment portfolios, confirmed by the increase in usage and popularity.

Investors need to understand ETF transparency better

As a research house, we contend that ETF selection processes and criteria need to move to another level beyond the current simplistic approach. Factors like funds under management (FUM), age of fund, performance (relative or otherwise), tracking error, issuer confidence, fees, ease of compliance, platform access et al are all, in our view, only the basics.

More work needs to be done to fully understand ETFs and the differences between them. A focus on only the basics misses too much critical information.

Fortunately, the transparency of underlying assets in ETFs allows a much deeper analysis, such as the sector and geographic allocations of each fund. Additionally, by applying the traditional tools of security analysis to each underlying constituent, we can develop a view of a fund’s investment potential based on fundamentals such as earnings growth and valuation multiples. This is a forward-looking approach.

ETF selection should be about building the appropriate research-based ‘investment case’ that matches an investment criteria. Our approach facilitates this for example by distinguishing which funds are most appropriate for a ‘growth at a reasonable price’-type investor versus which funds are better suited to an income-oriented investor.

As an example, a ‘plain vanilla’ equity ETF is simply a basket of equities that seeks to track a given index. We can calculate a detailed series of equities-specific data points (e.g., earnings growth, valuation multiples) as well as the investment exposure the fund holder receives. From there, we can begin to compare ETFs from within their peer groups and even across peer groups.

Under the hood: investing in Europe via ETFs

For example, within the ‘Europe’ peer group, Australian investors can access five equity-based options, one of which is hedged back to the Australian dollar. These come from five different issuers and track five different indices, as shown in Table 1.

Table1: Peer group of European ETFs in Australia



From this data, observations may conclude that older funds may generally have large and sticky Funds Under Management though they may be relatively expensive. Fees can range greatly, with younger funds generally being cheaper. There’s also a premium to pay for hedging and the stock count within each fund varies widely.

When we check the underlying assets, we find all five funds have at least some exposure to each of the ten major sectors, and each is reasonably well diversified, which is not always the case with ETFs. Still, there is plenty of variation, with HEUR offering little exposure to Energy at just 1.4% versus 7.4% for ESTX. For Consumer Discretionary they flip places, with HEUR at 18.3% of assets compared with 10.5% for ESTX.

Among country exposures the differences can be significant (Table 2). For example, while IEU and VEQ put about one-quarter of assets in Great Britain, ESTX and HEUR have none. Depending on how Brexit proceeds, that’s likely to have a big difference in returns!

Table 2: Major country exposures of European ETFs


We begin to see that the different rules of each index result in difference exposures. To quantify exactly how similar (or dissimilar) one fund is from another, we introduce Overlap Analysis, which measures the extent to which the positions in each ETF are identical.

Table 3: Overlap analysis of European ETFs


With ESTX as a reference, the overlap with HEUR is 48.3%, meaning nearly half of the fund’s positions are identical. This is important because differences in returns can only be generated from the portion of each portfolio which is distinct.

The more similar one fund is to another, the more important price becomes as a differentiator between products. For example, UBE has 78.2% overlap with IEU, and 72.3% with VEQ. This analysis cuts through sector and country allocation data and identifies an ETF’s ‘value for money’. It is also useful in comparing ‘smart beta’ products to the more traditional pure index ETFs.

Building the investment case

There’s more though to ETF selection than sector and country allocations, fees, past performance – real or back-tested – and other minor preferences. A detailed examination of the investment fundamentals is required to build a solid investment case. Table 4 has some important fundamental factors and valuation metrics, as well as the ALTAR Score™ - our proprietary measure of an ETF’s overall investment merit (like any rating, investors should consider it alongside other criteria when making a fund selection). Our calculations are based on reported results and consensus estimates for each underlying security in an ETF.

Table 4: Investment fundamentals and valuation metrics


Importantly, the data points above give investors more information on which to make a fund selection. There are usually trade-offs in fundamental data when selecting ETFs. The ALTAR Score™ is not the only thing to look at. For example, superior Net Margins and ROE of the underlying stocks bodes well for the investment characteristics of HEUR, although its higher Price to Book Value (P/BV) impacts yield (which may show the underlying stocks are in favour with current investors).

Understanding the trade-offs

Investing in ETFs — as with almost everything else — involves trade-offs. Table 4 illustrates some of the trade-offs that result between attractive valuations and profitability and growth. The beauty here is that the transparency of an ETF shows those trade-offs clearly. With the appropriate fundamental investment data and selection tools, more informed investment decisions can be made, ultimately creating a better match between an investor’s objectives and the available funds. If you invest in ETFs, as an individual, an advisor, a robo, a super fund, whatever your stripes: what criteria do you value?


Michael Turner is Head of Sales & Corporate Development at AltaVista Research, which is based in the US and has been operating in Australia since 2008. As a specialist ETF researcher, AltaVista covers 1,100 ETFs in the US valued at some USD2.15 trillion. In Australia, research covers 104 equities and fixed income ETFs. This article is general information and does not consider the needs of any individual.

October 20, 2016

Personally, I’m confused by anything that is not just a plain vanilla ETF and think there’s a lot of rubbish out there (seeing as ETFs are “the new black”). My understanding is that some of them don’t even hold any underlying securities to back them ?! (and charge well over the 'passive' management fees of around 0.1% to 0.4%)

Ironically, they fit the term “synthetic” very well (I would say ‘artificial’ in the same way “sweetener” is not “sugar”), because all of these very subjective, sometimes oxymoronic terms (“deep value”) you mentioned above – I just don’t bother investing in them because I don’t understand it. If someone else can make money from it, good luck to them, but I’ll pass.

Michael Turner
October 20, 2016

Chris, interesting comment. Education via clear knowledge is the key. I will happily run you through the ETF landscape of the plain vanilla ETFs (arguably, what ETFs were first designed to be) and those that fall outside of that concept. Yes, fees and underlying holdings do vary, usually in line with these variations and by product type, if you will.

Michael Turner
October 20, 2016

Indeed Ashley, they do - and then some. Though, arguably, not as detailed a set of quantitative analytic data as we - and our advisor clients - would suggest is needed for building a fully informed, client specific investment case. Indeed, this combined with the use of effective comparative and selection tools, is the true subject of the article, which I am sure you appreciate.

October 20, 2016

Worth noting that every ETF publishes daily their holdings and perhaps other data such as country exposures, etc.


Leave a Comment:



Why 2020 has been the year of the bond market

Lessons in oil ETFs, futures and negative prices

Global ETFs: insights into a multi-trillion-dollar industry


Most viewed in recent weeks

Have the rules of retirement investing changed?

In retirement, we still want to reduce stock volatility while generating cash flows. The two needs have not changed, but the reward expected in the old days from interest payments has gone. What should we do?

18 Aussie names for your watchlist

A Morningstar stock screener reveals a cross-section of companies with competitive advantages that are trading at material discounts to estimated value. This is a list of 18 highly-rated names worth watching.

One last hurrah for the 60/40 portfolio?

The 60/40 diversified portfolio has been the mainstay of the superannuation industry for decades. But it is built on a fundamental principle of defensive bond returns, and its time is nigh.

YourSuper will save $17.9 billion! Surely you’re joshing

In Budget 2020, Josh Frydenberg announced a performance comparison tool and fund stapling to save Australians $17.9 billion over 10 years. But too many moving parts make results highly cyclical.

Claiming a tax deduction for super contributions

The timing of lodging a notice of intent to claim a tax deduction on super contributions and making partial rollovers or withdrawals can make a big difference to the amount allowed to be claimed.

Hamish Douglass on what really matters

Questions on the stock market/economy disconnect, how to focus long term, technology's growing role, income in a low-rate world, Modern Monetary Theory and endless debt and the tooth fairy.

Latest Updates

Weekly Editorial

Welcome to Firstlinks Edition 380

Former US Vice President Al Gore once told me he needed to raise only US$70,000 when he first ran for politics. Now Biden and Trump spend billions just on television advertising. Little wonder so many favours are owed after each election, and this time, it really matters. Plus investing insights from Kate Howitt, Hamish Douglass, Roger Montgomery, Phil Ruthven and Morningstar's top stock picks.

  • 22 October 2020

Kate Howitt: investing lessons and avoiding the PIPO trade

Kate Howitt identifies the stocks she likes and the disappointments, gives context to the increasing role of retail investors, and explains why the market is more of a 'voting not weighing' machine than ever before.

Investment strategies

Hamish Douglass on what really matters

Questions on the stock market/economy disconnect, how to focus long term, technology's growing role, income in a low-rate world, Modern Monetary Theory and endless debt and the tooth fairy.

Investment strategies

Buffett and his warning about 'virtually certain' earnings

While many investors are happy to invest in any online companies, Warren Buffett focusses more on the quality of future growth, buying companies whose earnings are 'virtually certain' in 10 or 20 years from now.


18 Aussie names for your watchlist

A Morningstar stock screener reveals a cross-section of companies with competitive advantages that are trading at material discounts to estimated value. This is a list of 18 highly-rated names worth watching.


Are debt and its servicing cost serious worries?

The impact of the pandemic on Australia's debt and deficit has forced the government into borrowing on a scale unimaginable at the start of 2020. What are the implications, and what is even more important?

Investment strategies

Why not use options to protect your share portfolio?

Many investors ask why fund managers do not protect the portfolio downside by using options. All insurance has a cost, and achieving full protection is expensive, but there are other ways to use options.


A-REITs offering much-needed income

Many listed property stocks were hard hit by COVID, especially in retail, but foot traffic outside Victoria has held up relatively well. Some sectors are now good value for the recovery and less working from home.



© 2020 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.