Intelligent ETF

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.
  • Intelligent ETFs are not without their downsides, and interested investors need to thoroughly research the amount of "churn" a fund experiences.
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4 Reasons To Invest In ETFs

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.

Intelligent ETFs differ. A set of objective rules, which vary for each fund, are followed to select stocks based on investment merit. Adhering to 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.

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.

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 are heavily exposed, as it is these types of companies whose shares tend to fall hardest. This might not always be considered a disadvantage though, as a slight overweighting in a certain sector or security can lift the ETF price. This could be considered both an advantage or distance depending on the individual investor's risk tolerance.

ETFs do not directly track indexes. The adjusted weighting of certain stocks could leave an actively managed intelligent ETF vulnerable to a higher-than-normal amount of overvalued securities, increasing exposure to risk.

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.

Over time, higher expense ratios can eat away at growth. If a passively-managed fund has an expense ratio four times lower than that of an intelligent ETF, it could potentially offset the lack of gains and result in an overall higher return. Since ETFs were introduced, they are popular for a number of reasons, but most significantly for their ease of use, broad exposure, and low expense ratios. For this reason, it is important to consider the past performance of the fund when compared to a passively managed ETF to ensure the additional expense ratio is warranted.

Pros
  • Ability to adjust risk and exposure

  • Investment choices considered by a portfolio manager

  • Ability to exclude securities not favorable to investment strategy

Cons
  • The fund can be off-balance with a higher percentage of overvalued securities

  • Higher expense rations when compared to passively managed ETFs

  • Can be subject to human error

Special Considerations

Artificial ETFs

The logical next step in intelligent ETFs is 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.

Artificial ETFs are not to be confused with AI Etfs. The former is an ETF managed by an algorithm, whereas the latter is a basket of securities invested in companies engaged in artificial intelligence.

There are benefits and drawbacks to artificial ETFs. The most obvious benefit is that by employing less people to manage the ETF, the expense ratios are often lower. This can make a substantial difference to long-term growth.

A drawback would be that the ETF's selection and weighting is based on a powerful algorithm. Even if the algorithm is updated regularly, which most are, an investor is still invested in the algorithm which, if there are deviations, could result in a loss as the algorithm is less of a round table decision when compared to, say, a team of portfolio managers discussing options and risk tolerance.

What Does It Mean When an ETF Is Actively Managed?

When an ETF is actively managed, it means that a portfolio manager and their team monitors the ETF and buys and sells products to balance the ETF according to their rules and guidelines. This is not what an ETF typically does, as a typical ETF is passively managed which means that although there is someone overseeing the ETF, they are only making adjustments when the ETF deviates from the index or benchmark it is following.

Do Actively Managed ETFs or Passively Managed ETFs Have Better Returns?

Actively managed ETFs can, on the surface, appear to offer better returns. However, each investor needs to consider that actively managed ETFs typically carry a much higher expense ratio than a passively managed ETF. Even though the price of the ETF might increase, the higher expense ratio can erode that profit difference.

Are Vanguard ETFs Actively Managed?

Vanguard offers a significant amount of actively managed funds. Although their passively managed funds generally are more heavily invested in, there are over 100 actively managed funds available.

Are SPDR ETFs Actively Managed?

Similar to Vanguard, State Street Global Advisors, or SPDR, offers actively managed funds. As is the case with most actively managed products, SPDR's actively managed ETFs carry significant expense ratios when compared to their passively managed counterparts.

The Bottom Line

Intelligent ETFs can be a good addition to an investor's portfolio. However, that investor needs to consider the higher expense ratios associated with intelligent ETFs, and the increase in risk they take on since the ETF does not perfectly follow a sector or broad-based index.

One of the greatest benefits of an intelligent ETF is that the securities are actively managed, so a portfolio manager can choose to include or exclude a security based on that fund's strategy, potentially avoiding a loss. As with anything, human intervention can be either a benefit or drawback, and in the case of intelligent ETFs, it comes down to the individual investor's tolerance for risk.

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