Pure Passive ETFs – Pure passive ETFs are index ETFs that seek to track the returns of a specific benchmark and generally tend to follow a capitalization-weighted index (equity ETFs).3 Pure passive fixed income ETFs tend to follow a debt-weighted index.4 This product type dates back to 1993. Pure passive ETFs are relatively basic in comparison to other types of ETFs – very little product engineering usually goes into the creation of the indices that they follow. Unlike smart beta, passive ETF managers usually don’t collaborate with the index provider on the construction of a custom index. For pure passive ETFs, the key decision is which securities will be in the index; this is typically based on a weighted average.5
Smart Beta ETFs – Unlike pure passive ETFs, smart beta ETFs endeavor to take a unique approach to index construction. Yes, these products are passively implemented, but active investment choices inform decisions about which securities to include and the weighting of those securities. Smart beta ETF managers are usually very involved with the index providers in building the indices against which their ETFs will be tracked. It could be argued that smart beta ETFs are a watered-down version of active ETF products.
Active ETFs – Active ETFs are characterized by real-time decision-making around which securities are owned and what their weightings are in the product’s portfolio. The goal of active ETFs is to beat an index, but they have no requirement to look anything like that index. Beyond that, active ETFs have the ability to actively implement their security buy/sell decisions and trade as desired, rather than follow an index. This is a critical difference relative to pure passive or smart beta ETFs. In short, active ETFs can control what securities they own and when they own them.
The key difference between active ETFs and smart beta ETFs is that 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 that is decided by an index provider.
Trading decisions can make the difference
We have noticed some investors evaluating smart beta ETFs the same way they view pure passive ETFs, based on their understanding that both are seeking to track an index and have similar risks. However, smart beta ETFs make many more assumptions and generally require a custom index; pure passive ETFs generally do not. There are many active investment construction decisions being employed in smart beta. Therefore, we believe smart beta should be evaluated more like active ETFs. However, a key difference between smart beta ETFs and active remains: 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. This is a key potential advantage that the buyer receives with active management.
A note of caution
Both smart beta ETFs and active ETFs are complex investment vehicles that pose risks. Passive ETFs also pose risks, but they may offer a more straightforward story to investors and financial professionals who are researching allocation options. If the goal is to try and protect investors from the potential risks of active investment decision-making and product construction, investors and financial professionals may want to consider using the same product review process for smart beta ETFs that they use for active ETFs.
2 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 market. Smart beta strategies involve risk, including risk of loss.
3 A capitalization-weighted (or “cap-weighted”) index is a stock market index whose components are weighted according to the total market value of their outstanding shares.
4 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.
5 A weighted average is an average resulting from the multiplication of each component of a set by a factor reflecting its quantity or importance.
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.