In late 2017, ETF Managers Group made headlines when it swapped the benchmark for its Tierra XP Latin American Real Estate ETF (LARE) to the marijuana-focused Prime Alternative Harvest Index. The resultant fund, the ETFMG Alternative Harvest ETF (MJ), became the first pure-play marijuana ETF to hit the market (read: "When An ETF Changes Its Exposure").
At the time, the move shocked many industry participants and observers, but the index switch itself was and remains perfectly legal. That's because, for the vast majority of ETFs, there's no requirement that the index an ETF starts with must remain its benchmark forever.
By and large, that's a good thing. It gives ETF issuers the flexibility to swap indexes as needed, switching to a cheaper index provider or to a benchmark that tracks the intended investment objective more closely.
However, it also allows issuers to cannibalize their own ETFs, a practice that, while eliminating the expense and regulatory hassle of launching a brand new ETF, can also radically change a fund's investment objective without any input from the fund's current investors.
Why Issuers Change Indexes
Changing an ETF's benchmark index isn't all that uncommon an occurrence. Since the start of the year, 27 ETFs have changed their underlying indexes, while there have been hundreds of additional instances since 2003.
Historically, when this happens, ETF issuers have tried to maintain some consistency between their old and new benchmarks. Though index providers may change, or the breadth of the securities universe may be tweaked, a small cap ETF generally remains a small cap ETF, a tech fund a tech fund, and so on.
Other times, issuers change an ETF's index specifically because a significant exposure change is coming, and they want to smooth the ride for investors planning to stay in the fund. For example, in advance of the revisions to the Global Industry Classification Standard (GICS) that went effective last September, Vanguard switched several of its ETFs to a series of transitionary indexes that eventually resulted in new GICS-compliant benchmarks (read: "Changes Ahead For 24 Sector ETFs").
Sometimes, however, the change of a benchmark comes with little warning, and results in a dramatic change to the ETF, transforming large cap ETFs to small cap ones, or switching the focus from one single-country market to another.
For example, in 2017, Deutsche Bank switched the index of its Xtrackers MSCI Italy Hedged Equity ETF (DBIT), turning the fund into a single-country Germany ETF, the Xtrackers Germany Equity ETF (GRMY). (GRMY ceased trading earlier this year.)
Another radical change occurred back in 2013, when Exchange Traded Concepts switched the index of its existing Canadian oil sands ETF, transforming it into an income-focused fund of funds, the YieldShares High Income ETF (YYY).
The trend continues to this day. In the table below, we've listed some of the more striking index switches of 2019:
|Significant ETF Index Changes In 2019|
|Date||Old Ticker||Old Index||Old Exposure||New Ticker||New Index||New Theme|
|6/24||AUGR||BlueStar Augmented and Virtual Reality Index||Augmented/ Virtual Reality||VIDG||BlueStar Next Gen Video Gaming Index||Video Games|
|6/24||PXMG||Russell Midcap Pure Growth Index||Midcap Growth||XMMO||S&P MidCap 400 Momentum Index||Midcap Momentum|
|6/24||PXSG||Russell 2000 Pure Growth Index||Small Cap Growth||XSMO||S&P SmallCap 600 Momentum Index||Small Cap Momentum|
|5/29||FONE||Nasdaq CTA Smartphone Index||Cellphone industry (providers, retailers, etc.)||NXTG||Indxx 5G & NextG Thematic Index||5G Networks (infrastructure, tech, etc.)|
|2/22||DBAP||MSCI Asia Pacific ex Japan US Dollar Hedged Index||Hedged Asia Ex-Japan Equities||HAUZ||iSTOXX Developed and Emerging Markets ex USA PK VN Real Estate Index||Global ex-USA Real Estate|
Source: ETF.com; data as of July 7, 2019
Which ETFs Get Retrofitted?
For issuers, the cost/benefit analysis is clear: Retrofitting an existing structure with a new index is faster and less expensive than filing for a brand new fund. Taking a new ETF from concept to launch can run anywhere from $75,000 to $100,000. Retrofitting an existing fund costs about half that, by one issuer estimate.
Usually, the ETFs chosen for retrofitting tend to be low in assets and in trading volume. For example, when the decision was made to transition LARE from Latin American real estate to marijuana, the fund had only $6 million in assets and an average daily trading volume of $90,000.
Likewise, before the Defiance Future Tech ETF (AUGR) became the Defiance Next Gen Video Gaming ETF (VIDG), it had just $3.6 million in assets and an average daily trading volume of $1,900.
Because the targeted funds tend to be so low in assets, issuers rarely see a significant outflux of investor assets exiting their funds when the indexes eventually switch.
The right index switch can attract massive assets, however. Less than two weeks after its index change on May 29, the First Trust Indxx NextG ETF (NXTG) pulled in more than $100 million in new net inflows. (And of course, the post-switch MJ is now far and away the largest marijuana ETF on the market, with $1.1 billion in assets under management.)
That said, swapping an index is no guarantee that investor assets will come. For every MJ and NXTG, there are many more like GRMY, whose index switch failed to attract enough assets to save it from eventual closure.
Investors Get No Input
Complicating matters is the fact that investors do not have say into changes made in their funds' indexes, due to the way the Investment Company Act of 1940 was written.
The law governs "investment policies" of registered investment companies, including mutual funds and ETFs. (An example of an investment policy is a fund's investment objective, which often states its index by name.)
There are two kinds of investment policies: "fundamental" and "nonfundamental." A fundamental policy requires shareholder approval to change, while a nonfundamental one only requires at least 60 days’ written notice to investors.
ETF issuers may decide for themselves which investment policies they consider fundamental, thus requiring a vote from shareholders. Benchmark indexes usually don't make the cut.
As a result, when an issuer wants to change an ETF's index, no matter how drastically, usually all that's required is written notice to investors two months' ahead of the scheduled switch.
Performance Charts May Remain The Same
Investors should be aware that issuers can and usually do continue to point to an ETF's former track record in its prospectus and marketing materials for its new incarnation.
From an issuer's point of view, this can benefit untested ETFs, especially if the previous version of the fund had solid performance.
However, these historical performance charts can be misleading for investors, especially those unaware of the index switch and/or who do not know to look for the fine print.
As always, investors should vigilantly research every fund they invest in—especially ones for which they've recently received notice of an index change. Because when these changes occur, there's no guarantee that what your fund holds today is what it'll hold tomorrow.
Contact Lara Crigger at [email protected].