Know Your ETF

Many investors think of active and passive management as polar opposites, with nothing in common except the markets in which they operate. While this may be a popular notion, we believe it was never technically true. The question is not whether exchange-traded funds (ETFs) and other passive strategies are, in fact, managed investments, but rather how — and how much — they are managed.

All investments, including passive strategies, involve some degree of management because their very construction requires subjective decisions. That, in turn, means that if investors are looking to slot an ETF into a carefully crafted asset-allocated portfolio, it’s important that they understand the index parameters of an ETF, what securities are included (or excluded) from that benchmark, and how those requirements might influence expectations of future performance.

Emerging markets: An example of why you need to know

Emerging markets provide an example of a complex market that underlines the importance of benchmark awareness. In recent months, torrents of investor dollars have been flowing overseas, most notably into emerging markets. However, exchange-traded products mining this vast asset class can have greater variability in both construction and fees compared to those based on domestic benchmarks.

For instance, investors seeking equity exposure to South Korea might be surprised to learn that the indices on which the Vanguard emerging markets ETF product is based do not include stocks from the South Korean equity market. This is because index provider FTSE Russell considers South Korea a developed market not an emerging market — and Vanguard has been using FTSE indices for this ETF since 2013.

While it’s the prerogative of an index provider to determine the securities in an index, nonetheless, from the perspective of many investors, excluding South Korea from an emerging markets ETF can mean missing exposure to identifiable names such as Samsung Electronics or Hyundai Motor Company. Meanwhile, investors who may be in an emerging markets ETF based on MSCI methodology — as Vanguard’s was prior to 2013 — would find that the benchmark does include South Korea.

The CRSP scenario

An example of how index construction can potentially influence portfolio outcomes is found in another switch made by Vanguard. In 2013, Vanguard began using a different set of benchmarks, the CRSP* indices created by the University of Chicago, for some of its domestic equity products including small-cap passive strategies. While these kinds of benchmark decisions are made for perfectly valid business reasons, such a change can have ramifications for an investor not paying close attention. In this case, the move effectively increased the weighted market cap of those products. In practical terms, it shifted exposure to larger market-cap weighted stocks, so that an investor wanting exposure to the core segment of small-cap US stocks might have gotten a different exposure than expected. Investors would have especially experienced the effects during periods when smaller-cap equities outperformed.

This example shows the need to understand what’s in an index, especially when changes occur. But it also points to an opportunity to consider active management in order to get exposure to the intended asset classes and sub-asset classes, in addition to having professional investors curate a portfolio of their best ideas.

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