Beware the pied piper of passive investing

Changes in the underlying benchmarks of index-based funds could leave investors with undesired exposures

Beware the pied piper of passive investing

The trend toward passive-investment products has led to many benefits for investors, which include reduced costs and increased convenience. But investors in such index-investment vehicles, especially those who select their ETFs based on strong portfolio convictions, may not realize one key risk.

“Retail investors who buy passive ETFs may wind up with exposure to particular stocks or markets they are not fond of because of a fund’s mandate to match the index on which it’s based,” wrote Victor Ferreira in the Financial Post.

Relinquishing a tactical advantage
A case in point was the iShares MSCI Frontier Markets 100 Index ETF, which promised exposure to markets in such a nascent stage of development that they’re too illiquid and risky to be considered “emerging.” As of September 2017, it held 21% exposure to Kuwait and 18% to Argentina.

But after seven months, MSCI announced plans to remove Argentina from its frontier-markets index and promote the country into its emerging-markets index. The next year saw the portfolio space formerly occupied by Argentina being divided among African and Middle Eastern countries, many of which were oil-dependent. In June 2019, MSCI unveiled plans to upgrade Kuwait to emerging-market status.

Read also: What investors must consider as emerging markets come back

“If you’re a long-term investor and you want to just buy and hold for 30 years, maybe you look past that,” David Kletz, a portfolio manager at Forstrong Global Asset Management, told the Post. “But if your time horizon is a bit shorter, you really need to stay on top of what’s driving the ETF and continually ask yourself: ‘Is this something I’m comfortable with owning?’”

According to Kletz, a pervasive default view across the investment industry is to “go as cheap or passive as possible in absence of a more tactical view.”

Canadian portfolios appear to be swinging away from the tactical side, if aggregate asset levels are any indication. Horizons ETFs senior vice-president Mark Noble said that passive market-cap index strategies represented two-thirds of ETF assets in Canada; the global passive bias is even more severe, he added, with the worldwide number being closer to 90%.

Perils from rebalancing
Indexes are defined in a variety of ways. While some may follow commonly understood categorizations, ETF providers will sometimes work with indexing firms to build a custom benchmark; they may also work proactively to develop indexes that have the potential to draw attention as a base to build ETFs or index funds upon, FTSE Russell managing director of North American research Rolf Agather told the Post.

But however they come about, indexes have strict rules that dictate how portfolios should be rebalanced every month, quarter, or year, depending on how the rules are drawn up. “The point of rebalancing is to maintain the particular exposure outcome,” Agather stressed.

Critics contend that certain stocks represented in multiple ETFs through a benchmark may be unfairly dragged down during rebalancing, Horizon’s Noble said that can only happen when an ETF owns 10% to 20% of an issuance. Still, he acknowledged that rebalancing can lead to undesirable outcomes, such as when the North America Marijuana Index added Tilray just as it was trading at sky-high valuations; it later on lost 92% of its value in just over a year.

That action hurt the Horizons Marijuana Life Sciences Index ETF, which was forced to follow the benchmark. “From a fundamental perspective, that doesn’t feel good as portfolio manager, but we have an investment objective and obligation to replicate that index,” Noble said.

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