Intelligent ETF – What is it?

ETFs are basically index funds (mutual funds that track various stock market indexes) but they trade like stocks. Intelligent ETF refers to an exchange traded fund (ETF) that has an active investment strategy based on one of the bigger index markets. ETFs based on S&P 500 or a sector-based index is typically a so called smart ETF. Intelligent (or smart) ETFs started early in this millenium as a result of the bear market.

The ETF can exclude some stocks within the index while increasing or decreasing the percentage weighting of other stocks. Intelligent ETFs carry higher expense ratios than standard ETFs, as well as substantially higher turnover ratios. This is the natural outcome of having a more active investment strategy i.e. it costs more to entertain. An expense ratio of 0.5% per annum means that each year 0.5% of the fund’s total assets will be used to cover expenses. The average ETF carries an expense ratio of 0.44%, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest. The average traditional index fund costs 0.74%. It’s not uncommon for intelligent ETFs to carry a little higher expense ratio than that of regular or “unmanaged” ETFs but not as high as Index Funds.

Intelligen ETFs in Practice

Most intelligent ETFs tries to avoid market capitalization-weighted portfolios. They instead use so called black box systems with a proprietary formula for determining which stocks to pursue. The forumla can be based on various types of company metrics such as company fundamentals or share performance.

A smart ETF or index fund (or regular ETF for that matter) that does not replicate a base index is not passive investing. This means that it can deviate vastly from the returns of the benchmark index. Some intelligent ETFs have proprietary indexes that are replicated within the ETF, but this is still active investing, and many of the internal indexes cannot be readily examined.

Note: If you’re thinking about investing in a life-cycle fund that invests in intelligent ETF, remember to see if it will charge an extra management fee for the higher expense ratio often associated with smart or intelligent ETFs.

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