What Is an Intelligent ETF?

An intelligent ETF is an exchange-traded fund (ETF) that employs an active investment strategy based on a broad index, such as the S&P 500, or a sector-based index. The fund may choose to exclude some stocks within the index while increasing or decreasing the percentage weighting of other stocks.

Most intelligent ETFs carry higher expense ratios than standard ETFs, as well as substantially higher turnover ratios. An intelligent ETF is also known as a smart ETF. 

Key Takeaways

  • An intelligent ETF is an exchange-traded fund (ETF) that employs an active investment strategy based on a broad or sector-based index.
  • A set of rules is followed, enabling funds to exclude some stocks within the index while increasing or decreasing the percentage weighting of other stocks.
  • Rules that intelligent ETFs impose vary by fund and may be related to the valuation of stocks, company fundamentals, share performance or some other factor.
  • Intelligent ETFs can mitigate the problem of capitalization weightings present in most regular, passive ETFs, although this extra work comes at an additional cost.

How an Intelligent ETF Works

The majority of ETFs are passively managed, aiming to replicate the returns of the broader equity market or a specific sector or trend by mirroring the holdings of a designated index — a hypothetical portfolio of securities representing a particular market or a segment of it.

2:13

4 Reasons To Invest In ETFs

Intelligent ETFs differ. A set of objective rules, which vary for each fund, are followed to select stocks based on investment merit. Adhering by these guidelines leads the fund to deviate from the base index. That automatically makes intelligent ETFs active vehicles, even though stock picking and weightings aren’t left entirely to a portfolio manager’s discretion.

Important

Any ETF or index fund that does not replicate a base index is not passive investing, meaning that the fund's returns could deviate markedly from the returns of the benchmark index.

Some intelligent ETFs have internal or proprietary indexes that are merely replicated within the ETF. Many of these internal indexes cannot be readily examined, though, and do not constitute passive investing as they differ from and seek to beat the official benchmarks.

Rules that intelligent ETFs impose may be related to the valuation of stocks, company fundamentals, share performance or some other factor using internal metrics or black box systems, a computer program designed to transform various data into useful investment strategies.

Advantages and Disadvantages of an Intelligent ETF

Regular, passive ETFs mirror indexes, most of which tend to be capitalization-weighted. This means that the bigger the stock is, the higher the weighting percentage it has in an index and the ETF that’s tracking it investment portfolio.

A major downside to this approach is that it reduces diversification and leaves ETFs stuffed with the most overvalued stocks in the market. When the bubble bursts, investors get burnt as it is these types of companies whose shares tend to fall hardest.

Many "intelligent" or "smart" ETFs originated in the aftermath of the 2000-2002 tech craze as a remedy to the overvaluation of this market.

Intelligent ETFs mitigate this problem by creating a set of rules used to choose stocks for the fund and to weight them. This extra legwork does come at an extra cost, though: Most intelligent ETFs carry higher expense ratios than standard ETFs, as well as substantially higher turnover ratios.

Special Considerations

Artificial ETFs

The logical next step in intelligent ETFs are artificial ETFs: Intelligent ETFs chosen and managed by computer programs that follow set guidelines and analyze funds to find the best performers within the constraints of the given rules. 

The sheer number of stocks artificial ETFs are able to scrutinize gives them the advantage over traditionally-managed intelligent ETFs. In fact, since they started being introduced in 2017, they have largely succeeded in outperforming the rest of the market.