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Portfolio construction

How to evaluate ETFs

July 02, 2024 - 3 min read

Since Natixis Investment Managers has been an issuer in the exchange-traded fund (ETF)1 marketplace, we’ve analyzed ETFs ranging from purely passive products that simply follow an index, to active ETFs where managers make opportunistic security selection decisions aimed at enhancing returns while mitigating risk. In today's challenging markets, all varieties enjoy distinct usage depending on an investor’s investment objectives, risk tolerance and return expectations. We offer a few tips on evaluating the benefits of each.

 

Pure passive ETFs

These index ETFs track the returns of a specific benchmark and generally follow either a market capitalization-weighted2 (equity ETFs) or a debt-weighted3 (fixed income ETFs) index. They are generally suitable for investors seeking market-comparable returns with minimal security selection and concentration risk. Pure passive ETFs are relatively basic compared to their ETF counterparts, as minimal product engineering is typically involved in creating the indexes that the ETF will follow. Passive ETF managers usually don't collaborate with the index provider to construct a custom index, as the ETF securities are selected based on simply following the designated index. Their primary goal is to track the designated index and mirror its performance while mitigating management fees.

 

Smart beta ETFs4

Smart beta ETFs endeavor to take a unique approach to index construction. While passively implemented (meaning that they track an index), active investment choices do inform decisions about how securities should be weighted via a predetermined, rules-based methodology. These products may be equally weighted or weighted based on factors such as quality, yield, momentum, volatility, etc. They offer investors greater diversification and return potential without the exposure risk of full active management. Smart beta ETF managers typically collaborate very closely with index providers to build custom indexes against which their ETFs are tracked. One could consider this option as a watered-down version of the active ETF in that they aim to provide alpha5 over traditional indexes by leveraging a more systematic approach.

 

Active ETFs

Active ETFs are characterized by real-time security selection decision-making regarding the securities selected and the security’s portfolio weightings. While active ETFs aim to beat an index, they are not required to look anything like that index. Active ETFs allow the portfolio manager to trade – rebalance, add, or remove individual securities – when they believe the time is right, rather than on a predetermined basis decided by an index provider (as in smart beta ETFs). In volatile markets, this distinct characteristic can be particularly useful, as the portfolio manager is able to leverage in-house research to uncover compelling opportunities resulting in short- or long-term outperformance. The goal for active ETFs is clear: to provide risk-adjusted outperformance over a stated benchmark index.

 

Portfolio manager discretion can be advantageous, while carrying unique risks

We’ve noticed that some investors evaluate smart beta and pure passive ETFs in a similar fashion based on the understanding that both aim to track an index. However, the former makes more assumptions and generally requires a custom index, while the latter does not. As we’ve noted, various active investment construction decisions are employed in smart beta ETFs. As such, we believe investors and financial professionals should grant these products the same rigorous analysis that they do for active ETFs. The portfolio manager’s freedom to trade active ETFs at their own discretion rather than on a predetermined basis can be a key advantage but will generally lead to higher management fees on a relative basis.

Both smart beta ETFs and active ETFs are relatively sophisticated investment vehicles that pose risks. Passive ETFs may pose risks but could offer investors and financial professionals a more straightforward portfolio allocation option. An investor’s investment objective, time horizon, risk tolerance and return expectations should guide which type of ETF best suits their long-term goals.

We hope these insights are helpful. Please reach out to our ETF team to discuss these and any other questions.

1 An exchange-traded fund, or ETF, is a marketable security that tracks an index, commodity, bonds, or a basket of assets like an index fund. ETFs trade like common stock on a stock exchange and experience price fluctuations throughout the day as they are bought and sold.
2 A capitalization-weighted index is a stock market index whose components are weighted according to the total market value of their outstanding shares.
3 A debt-weighted (or bond market) index is a method of measuring the value of a section of the bond market, computed from the prices of a selection of bonds, typically a weighted average.
4 Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the marker. Smart beta strategies involve risk, including risk of loss.
5 Alpha is a measure of the difference between a portfolio’s actual returns and its expected performance, given its level of systematic risk. A positive alpha indicates outperformance, and a negative alpha indicates underperformance over a stated benchmark index.

Exchange-traded funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Active ETF: Unlike typical exchange-traded funds, there are no indexes that an active ETF attempts to track or replicate. Thus, the ability of an active ETF to achieve its objectives will depend on the effectiveness of the portfolio manager. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.

Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.

ALPS Distributors, Inc. is the distributor for the Natixis Loomis Sayles Short Duration Income ETF, the Natixis Vaughan Nelson Select ETF, the Natixis Gateway Quality Income ETF, and the Natixis Loomis Sayles Focused Growth ETF. Natixis Distribution, LLC is a marketing agent. ALPS Distributors, Inc. is not affiliated with Natixis Distribution, LLC.

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Natixis active ETFs

Need more insights for evaluating your ETF options?

Natixis Gateway Quality Income ETF (GQI)

Natixis Loomis Sayles Focused Growth ETF (LSGR)*

Natixis Loomis Sayles Short Duration Income ETF (LSST)

Natixis Vaughan Nelson Select ETF (VNSE)

This ETF is different from traditional ETFs – traditional ETFs tell the public what assets they hold each day; this ETF will not. This may create additional risks. For example, since this ETF provides less information to traders, they may charge you more money to trade this ETF’s shares. Also, the price you pay to buy or sell ETF shares on an exchange may not match the value of the ETF’s portfolio. These risks may be even greater in bad or uncertain markets. See the ETF prospectus for more information.