Examining Your ETF: Active, Passive & 'Smart Beta' Indexes

Investors looking to build a portfolio of ETFs may get caught up in the analysis of the fund provider, fees and tax structure. When selecting an ETF, however, the single most important determining factor is how the index is constructed.

The makeup of the underlying portfolio of assets is key because it determines how the ETF will react to a variety of market conditions. This includes the security selection, weighting methodology and ongoing changes to the fund construction over time.

Passive Indexes

Typically the lowest-cost funds are passive indexes like the Vanguard S&P 500 ETF (NYSE:VOO) or Schwab U.S. Broad Market ETF (NYSE:SCHB). Both ETFs offer annual expenses of 0.05 percent or lower and track well-known indexes that rarely change over time. This style of fund is perfect for a long-term core holding that will be a foundation to build tactical or alpha-seeking exposure to your portfolio.

Active Funds

On the other side of the spectrum are active ETFs such as the PIMCO Total Return ETF (NYSE:BOND). This style of fund allows a portfolio manager the flexibility to select securities they feel are going to outperform a passive benchmark based on their proprietary research. Typically active ETFs come with higher fees as a result of greater maintenance needed for the fund.

Because active funds typically select a unique mix of assets to try and beat their benchmark, the funds also come with the unknown quantity of either beating or lagging the preferred yardstick.

'Smart Beta'

The last style of enhanced ETF index, or smart beta, is a cross between active and passive as a result of rules-based analysis of the underlying securities. Typically these funds analyze fundamental balance sheet characteristics, performance data and a host of other technical data.

The goal is to create a semi-active ETF that is reevaluated and rebalanced on a regular (typically quarterly) basis to ensure the top securities within the index methodology are always included.

One example of a smart beta-style fund is the iShares MSCI USA Momentum Factor ETF (NYSE:MTUM), which selects 125 stocks according to recent positive six- and 12-month price returns. Currently the top sectors in MTUM are healthcare, industrials and information technology, which are subject to change according to fluctuating market dynamics.

Each style of index has significant merits that should be evaluated in the context of your investment goals, risk tolerance and time horizon. At some point, an investor may intentionally or inadvertently own a mix of all three depending on their style of investing.