Passively managed exchange traded funds usually do not make wholesale changes to their portfolios. Most of the underlying indices for passive ETFs rebalance quarterly and even then, holding and sector changes often boil down to just a few basis points.

However, there are circumstances where issuers of passive ETFs opt to take a more active approach. The meltdown in Puerto Rico’s municipal bond market is proving to be a prime example.

“Fears about Puerto Rico’s escalating fiscal woes underscore how passively run ETFs use a sampling approach to mimic the performance of an index. They’re not obligated to own each of the thousands of constituents there are sometimes in an index, but instead can select the ones they want to track it, according to fund disclosures to investors about their management approach,” report Tim McLaughlin and Ashley Lau for Reuters.

The $1.1 billion Market Vectors High Yield Municipal Index ETF (NYSEArca: HYD) is an example of a passively managed ETF that has noticeably trimmed its exposure to Puerto Rican debt. HYD applies a sampling strategy in tracking the Barclays Municipal Custom High Yield Composite Index (LMEHTR).

However, HYD allocated just 4.3% of its weight to Puerto Rico at the end of June, according to Market Vectors data. That makes Puerto Rico the ETF’s eighth-largest geographic weighting and barely more than the half the weight allocated to California munis.

“I see Puerto Rico’s debt restructuring legislation signed into law two weeks ago, combined with another wave of downgrades by Moody’s, as reference points for the current market. I believe it is an inescapable truth that taxable buyers of Puerto Rico debt seem to be providing some important liquidity for this market,” said Market Vectors Portfolio Manager James Colby in a note out earlier this month. [All Eyes on Puerto Rico]

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