How to evaluate ETFs

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 ETF) or a debt-weighted³ (fixed income ETF) 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. Although 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 it aims 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 each security’s portfolio weighting. Although 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 also 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.