Enhanced ETFs vs. Active ETFs

by: Shishir Nigam

While the ETF industry as a whole is growing at a breakneck pace, two areas within the field are growing even faster – actively-managed ETFs and ETFs following “enhanced” indices.

There is an important distinction between these two varieties though that should be noted. Enhanced indices are those that are not your traditional indices that just incorporate all the stocks in a particular sector niche, or market index. Instead, enhanced indices apply a screen or selection strategy that moves the composition of the index away from what a completely passive selection would have been. How they do this depends on what the index issuer is trying to achieve or market.

For example, some of the most popular enhanced indices are the FTSE RAFI indices. In this case, the index provider chooses to follow a fundamentally-weighting strategy in developing their indices, instead of a conventional market-weighting. Other enhancement strategies include applying exclusion rules which results in the formation of socially-responsible indices, green indices or even faith-based ETFs launched recently by FaithShares. This article provides a good description of various enhanced indexing strategies.

However, ETFs that follow such enhanced indices cannot be classified as actively-managed ETFs. While there is some discretion involved on the part of the index provider in selecting the companies that are admitted into the index being followed, the only responsibility of the actual manager of these ETFs is the same as that of all other Index ETFs – to track the underlying index as closely as possible. If you look at the prospectus of these ETFs, the investment objective will always be to replicate the performance of the underlying index.

On the other hand, managers of truly actively-managed ETFs aim to outperform the index they are benchmarked against, if any. They are not meant to track any underlying index and do not seek to represent or replicate the performance of a sector or index. These managers engage in making active security selection decisions that are not made by other managers, including those of enhanced ETFs. Find a complete list of actively-managed ETFs trading on the US and Canadian market here.

Disclosure: No positions in above-mentioned names.

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