ETF Changes Course With Investors Aboard

A sea change, not a style drift, hits IFSM.

While you were on vacation, an ETF changed its game, and its name.

The iShares Developed Small-Cap ex North America ETF (IFSM | D-86) became the iShares MSCI Europe Small-Cap ETF (IEUS). In short, the fund jettisoned its Japan, Australia and Korea exposure, which totaled about one-third of the portfolio.

The term for this in the ETF industry is “soft closure”: The issuer (BlackRock) has made a material change to the expected performance outcome and exposure. This is hardly new; if anything, the trend seems to be accelerating. Presumably, the issuer reviews its product line just like any other firm and devotes resources where it feels it can be successful and add value as a whole to its clients.

However, rationalizing a product line of investment vehicles differs from doing so to a line of cat food or dish soap; namely, because clients own the product that’s being changed. In this case, owners of IFSM—a fund with a stable asset base of $45 million—left for the long weekend with one portfolio and came back to another, IEUS.

I contrast this abrupt sea change in an indexed fund to the style drift that active managers are often accused of.

The point here is simple: Those of us on the ETF bandwagon can’t be too smug about an active manager tacking away from her mandate when an ETF issuer can arbitrarily change indexes. The point is that the index change can have a much greater impact than an active manager’s style drift.

Now, the caveats:

• First: Most fund documents include language for the issuer to make material changes to the investment policy—and that’s clearly the case here.
• Second: BlackRock has plainly highlighted the change on the fund’s home page—a simple step that some other issuers have whiffed on in similar circumstances. This lets would-be new investors know that the exposure is about to change.
• Third: While I’m not crazy about the means, the “new” fund actually fills a void for pure-play coverage of developed Europe small-cap equities.

Practical Considerations

Those who still want something close to the old exposure have other large and liquid fund options to trade into.

The Schwab International Small-Cap Equity ETF (SCHC | B-86) includes Korea, as did IFSM, but includes a hefty stake in Canada. The iShares MSCI EAFE Small-Cap ETF (SCZ | B-88) meanwhile excludes both Canada and Korea. In other words, neither ETF is a perfect replacement for the former IFSM.

Those who stay in IFSM and become holders of IEUS—and new investors, for that matter, who purchase IEUS—have a bit of tax risk.

The fund needs to sell off its Asian stocks—again, about one-third of the portfolio. Depending on the tax basis for the shares, current prices of the shares and any banked unrealized losses, the turnover could produce a capital gains distribution. If this occurs, it would likely be in December 2014.

The moral of the story: Even plain-vanilla, index-based ETFs need minding.

At the time this article was written, the author held no positions in the security mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.