From the October 2013 issue of Investment Advisor • Subscribe!

It’s Not Your Father’s Index Fund

Self-index ETFs blur the lines between actively managed and indexed

While ETFs have made the investing world a better place, it is not all rainbows and sunshine. Back in the old mutual fund days—before ETFs came to market—the difference between active management and an index strategy was fairly easy to determine. Active strategies could be fundamental, technical and even quantitative. Today, ETF indexes come in all shapes and sizes: dividend weighted, fundamentally weighted, wide moat, high dividend, low dividend, low volatility—they keep going like the Energizer Bunny. Somewhere a traditional passive benchmark became lost in what is quantified and sold as an index.

An obscure index that compares its performance to other indexes can present challenges to buy-and-hold investors and advisors balancing their client portfolios in pursuit of better risk-adjusted returns. The latest ETF news is not making boundaries any clearer as the SEC now more broadly allows self-indexing. A fund sponsor can create a strategy, call it an index, then offer an ETF based on that index. Many investment firms, both large and small, have applied for permission to offer self-index ETFs with the SEC.

ETF firms originally developed custom indexes through third-party licensing partners. Now they can further customize an index or develop their own self-index and potentially save significant costs in licensing fees, at least relative to the overall ETF fee. Savings passed on to ETF shareholders would be an ideal development, but it remains to be seen whether any transition from a third-party index to a self-index will provide better returns.

Returns are paramount as advisors navigate the alphabet soup of different index names and cloudy definitions. In many ways, these indexes look like active management, especially in how an investment firm decides on underlying constituents and creates the process for index rebalancing. However, neither custom indexes nor self-indexes have the full discretion of an active strategy. The ability to take full discretion is an important feature of active management as portfolio managers seek to provide better risk-adjusted returns and not just static exposure. An advisor should consider the following factors when analyzing custom indexes and self-indexes.

Strategy Buckets

It is imperative to understand the range of an index’s capabilities and limitations after becoming educated on its strategy. A beneficial practice is grouping indexes within their specific asset classes, such as domestic equity, international equity or emerging market bond.

Peer Comparisons

Every custom index or self-index is created because the ETF sponsor believes they offer a better investment option. Take the time to make the comparison. Evaluate how custom indexes and self-indexes correlate to each other, perform in up and down markets and ultimately perform against traditional benchmarks. Analyzing these indexes similarly to actively managed strategies under such circumstances can help.

Portfolio Construction

Many advisors take a balanced approach between traditional passive index strategies and actively managed strategies, building portfolios with each necessary component for a client’s overall investment objective. Custom indexes and self-indexes will likely assume traditional index allocation space. These strategies seek to be similar to traditional benchmarks, but aim to provide better returns for their exposure.

Advisors will find analyzing new self-indexes similar to analyzing active strategies and will ultimately utilize them as a complement to traditional indexes, helping better navigate their clients’ investment objectives.

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