The Human Decisions That Affect Passive ETF Holdings

Index-tracking funds come with an implicit assumption: The rules that govern how a fund selects, weights, and trades stocks or bonds shouldn’t change.

That provides investors with a clear, transparent understanding of what a fund will hold and how it will trade. Many believe rules-based strategies avoid emotional investment decisions that can derail human managers.

However, human index providers and fund managers still have a hand in the risk/reward profile of index funds. Here’s how active decisions can affect ETF holdings and ways investment professionals can adapt.

An index fund can only be as good as the index it tracks. Nuances in construction can cause performance to diverge between seemingly similar index strategies.

Morningstar analysts compiled a simple checklist of six characteristics to consider when evaluating index funds:

• Representative. Index providers try to minimize transaction costs by focusing on more-liquid securities. However, too-restrictive liquidity screens can exclude securities from an index and lead to only partial market representation.

• Diversified. The best indexes diversify away from risks the market doesn’t reward.
• Investable. Indexes that invest in illiquid securities can be hard to track or have limited capacity, meaning that they aren’t practically investable for portfolio managers.
• Transparent. Among multifactor funds, optimizers are a common way to balance competing objectives and constraints. However, their opaqueness can leave investors with something other than what they bargained for.
• Sensible. Index rules should be driven by sound economic rationale.
• Low turnover. Good indexes take strides to dial back undue portfolio turnover.

Indexes aren’t static. Companies go public, go bankrupt, or gain or lose market share, which all affect who meets index inclusion criteria.

Index providers try to balance tracking performance and taming transaction costs.

To lower turnover and trading costs, some providers reconstitute their indexes less often. FTSE Russell, for instance, reconstitutes its benchmark indexes once a year. Buffer rules that allow securities to temporarily stray from index criteria have become the norm. That means an index fund could drift from its original exposures and the goals of its investors.

Changing an index-tracking fund’s target index isn't common, but it’s not rare.

Morningstar researchers looked at roughly 1,200 index-tracking funds to identify those that had switched target indexes. Roughly one-fourth of the index-tracking funds in the sample set studied, or 310 funds, had changed their target indexes at least once. In some cases, the same fund changed its target index multiple times.

More substantial differences arose when tracking error exceeded the 3% threshold. Let’s look at Invesco S&P 500 GARP ETF, or SPGP, as an example.

The Invesco fund replicated the Russell Top 200 Pure Growth Index before June 21, 2019. It has since tracked the S&P 500 Growth at a Reasonable Price Index. The tracking error between these two indexes was nearly 7% over the five years before the switch because they are very different strategies.

The former indexes focus on stocks with the most expensive price multiples in the US market. The latter holds growth stocks, but those trading at lower multiples.

For a deeper dive, download the full report on target index changes.

ETF investors need more than a set-it-and-forget-it approach. Keep an eye on prospectus documents and amendments for any pivots in approach.

With Morningstar data and research, you can answer questions about:

• Index changes. A new data point in Morningstar Direct tracks the history of an index fund’s target index.
• ETF index tracking. How well do different funds replicate an index?
• Concentration risk. Does a fund or portfolio hold too much of one stock, investment style, or sector? How does it stack up against peers or benchmarks in asset allocation?
• Top unique and common holdings. Discover the fundamentals driving differences in returns. How many overlapping securities do two funds have, and how much of the portfolio do they make up?