Note: This article appears on the ETFtrends.com Strategist Channel

By Tyler Denholm, CFA

Some Things Never Change…or Do They?

A popular debate in the asset management industry is “passive” vs. “active” investing.  Index-based investment vehicles have gathered a significant amount of assets over the last decade, to the detriment of active investing, perpetuating this debate even further.

While there is a misconception among some in the investing public surrounding the attributes of index-based investing, there is nothing “passive” about managing an index-based portfolio. As such, we tend to dislike using the word “passive” and instead prefer “index”. Not only does tracking the index require skill and resources, but the creation of the index and constant monitoring require experience and astuteness

From the set-up of the portfolio allocation, selection of the underlying investments, to the ongoing monitoring and account maintenance, a lot of time, energy and resources are devoted to these so-called “passive” strategies.

Read the Label Before Digging In

We are constantly bombarded with labels and disclosures in our lives.  From the food we eat to the shirt we wear, nearly everything has a label.  This often numbs our senses when it comes to certain items.  Likewise, we typically don’t understand more than 50% of the ingredients in our breakfast cereal, let alone something more technical.  Instead of differentiating through the information on the label, the annoyance and complexity of the label itself often drives us to view things as commodities.

We believe that many investors have this same attitude concerning index investments. With the complexity of the disclosures, investors tend to rely instead on the broad marketing names of the funds.  This can be a dangerous strategy.

Remember to Monitor

One area of index-based investing which requires a lot of time is the ongoing monitoring of the underlying indexes.  This is a task which many investors do not think much about, but can have a profound impact on their portfolio.  Investors often buy a large cap fund that tracks the S&P 500 index fund, for example, and expect it to track the S&P 500 forever.  However, what if that large cap index fund switches indexes to the Russell 1000?  While not a large change in allocation, it could have impact on other, overlapping holdings in the portfolio.

Examples are Common

Last summer, Vanguard announced a series of index changes to four of their international equity ETFs. Specifically, Vanguard Emerging Markets Stock Index (NYSEArca: VWO) moved from the FTSE Emerging Index to the FTSE Emerging Markets All Cap China A Inclusion Index. The goal for the change was twofold:  broader diversification and exposures to new markets.  While both of these objectives are great investment ideas, if an investor was not monitoring the indexes being tracked by their investments, their portfolio exposures could have unexpectedly shifted.

Taking a look at each goal separately, we can see how changing the underlying index has an impact on the position’s exposure.  First, the broader diversification was achieved by the inclusion of small cap equities.  Before the inclusion, an investor may have been using a different fund to gain exposure to emerging markets small cap.  If adjustments are not made, they may now have an overweight to this asset class without realizing it.

FTSE_Emerging_Markets_All_Cap

The second objective was providing exposure to new markets, mainly the China A share market.  China A shares are equities which trade on the Shanghai and Shenzhen stock exchanges and were historically only available to domestic Chinese investors.  It is a sizeable market with $6 trillion of market cap at the end of 2014 so their inclusion into the FTSE Index, and subsequent VWO Index change were significant events.

FTSE-Emerging-Index

As can be seen above, the overall exposure to China within the ETF increased from 26% to almost 30% once the index transition is completed.  Again, an investor who built their overall portfolio allocation utilizing exposure information from the old index may unknowingly be increasing their overall exposure to China. In this instance, an investor may look to complement VWO with an ETF like EGShares EM Core ex-China ETF (NYSEArca: XCEM) in order to get the overall China exposure back to the initial level.

Index-based investing is not a set-it and forget-it operation.  It is important for not only retail investors, but also financial professionals to continuously monitor their investment vehicles to ensure appropriate exposure for their portfolios.  Index changes, while infrequent, do occur and can have a dramatic impact on the exposure of a portfolio, depending on the level investment concentration.

Tyler Denholm, CFA, is Vice President – Investment Management and Research of TOPS/ValMark Advisers, a participant in the ETF Strategist Channel.

Important Disclosure: VWO and XCEM have been, may be and/or are currently held in several TOPS® Portfolios.

ValMark Advisers, Inc. (“ValMark”) is a federally registered investment adviser located in Akron, Ohio. ValMark and its representatives are in compliance with the current registration and notice filing requirements imposed upon federally covered investment advisers by those states in which ValMark maintains clients. For registration or additional information about ValMark, including its services and fees, a copy of our Form ADV is available upon request by contacting ValMark at 1-800-765-5201.  This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal. Past performance is no guarantee of future results. Information contained herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.  Indexes are unmanaged and cannot be directly invested in.  TOPS® is a registered trademark of ValMark Advisers, Inc.  Diversification does not prevent or guarantee against loss.

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