What makes a good ETF? The play’s not the only thing.

As an undergraduate, I was a dual degree in theater and finance, but until graduation my practical work experience was entirely backstage in performance production. I often get asked if there are applications to my work today as CIO of iShares ETFs and Index investments. My answer: absolutely.

In the world of index investing, “performance” means something very different than it does in the theater, of course. But just as a great theatrical performance requires the coordinated efforts of set designers, sound and lighting engineers, costumers, and stagehands, excellent index investment performance has several distinct dimensions.

Many investors understandably focus first on fees. As with anything you buy, there are costs associated with investment products and it’s important to be aware of all charges and fees before investing. Exchange Traded Funds (ETFs) typically cost less than comparable mutual funds and are generally tax efficient, features which can generate better long-term performance, helping you reach your financial goals.

But there’s more to performance than “just” keeping a close watch on fund fees and tax efficiency. In a world where fees are trending toward zero — many ETFs are available commission-free, for example — there are other factors investors need to pay attention to when evaluating potential investments, as well as existing holdings. 

Let’s take a closer look at how we measure investment performance for our index mutual funds and ETFs, which seek to replicate the performance of an underlying index, like the S&P 500.  

Two elements are key to measuring investment performance: The precision of our index funds and the market quality of our ETFs.

Precision is a measure of how well index funds replicate the performance of an underlying index, and their ability to do so consistently over time.

The precision of an index fund can be assessed by the following:

• Tracking difference, which measures the difference between a fund’s return and that of its benchmark index.
• Tracking volatility, which measures the standard deviation (i.e., the volatility) of an investment’s tracking difference month-over-month.¹
• Rebalance efficiency, which measures how effectively the fund delivers index outcomes. Most index providers rebalance their indexes regularly, adding or removing securities or changing the weights of existing index constituents. As a result, index fund managers must reconfigure portfolio holdings to match the rebalanced index so they can achieve their index-tracking objectives.

Market quality refers to the ability of ETFs to offer investors liquidity, price discovery, and efficient access under varying market conditions. As with precision, various elements go into an ETF’s market quality, including:

• Trading dynamics such as average daily volume and bid-ask spread are common measures of market quality. The bid-ask spread is the difference between the price an investor is willing to buy a security (the bid) and the price at which its owner is willing to sell (the ask). High and/or rising average daily volumes, and tight bid-ask spreads typically indicate strong market quality.
• Premium-discount behavior refers to whether an ETF’s market price per share is above, below, or equal to the net asset value (NAV) of its underlying holdings. Multiple factors go into evaluating premium/discount behavior, including market conditions and the liquidity of the underlying market. For example, an ETF trading at a price per share close to its NAV can reflect stable or liquid markets. Meanwhile, the appearance of premiums or discounts amid heightened volatility can illustrate how ETF prices provide price discovery. Both are indicators of market quality.
• Underlying market impact is measured by the ratio of an ETF’s secondary market activity to its primary market activity (the “STP ratio”). A higher STP ratio suggests the ETF’s trading is being efficiently processed with minimal market impact, meaning shares of underlying securities do not need to be bought or sold to adjust for changes in investor demand. Imputed flow, the measure of how ETF inflows and outflows influence the trading of individual stocks, is another way to measure market impact.

We believe it is essential for investors to have a way to consistently measure investment performance over time. Our framework can help investors understand how index funds, including index ETFs, track their indexes and deliver market quality in all market conditions. It’s also a good reminder there’s nothing passive about index fund management.