Your ETF Undergoes an Index Change? Here's What You Should Do

Kate Lin: We've seen examples of managers changing the investment objectives of the ETF they manage, either to cater to client preferences for a specific region or to reflect ESG considerations. But what do these changes mean if you have invested in an ETF that changes its objectives? What should you do?

To help us answer these questions is Jackie Choy, our global director for passive investment ratings. Jackie, tell us what happens to an ETF when a manager decides to change objectives.

Jackie Choy: Hi Kate. Speaking about a passive ETF that tracks an index, when an ETF manager changes its investment objective for any reason, there will be an accompanied change in the benchmark index that it tracks. The new index would have a different set of index methodology to match with the new objectives, and existing investors would be notified about such change.

Lin: Could you give us examples of managers who have done this?

Choy: So, some examples recently in a change of investment objectives, I think especially in the past few years in Europe, there was a number of switches from a core market index to an ESG version of the index. This kind of change could have been driven by various reasons. It could have come from investor demand or business needs. For example, say one manager acquires another fund manager. There might be overlaps in the two firms' product lineup, where there might be two ETFs tracking the same index. So the management would potentially consolidate the two ETFs or decide to change the objective of one of the two ETFs.

Lin: So, I think this brings us to the practical side of the question to investors. So when this occurs, how can investors evaluate the potential impacts?

Choy: So first of all, I think that the investor would need to do some homework. The investor should understand what was actually changing. In particular, what is the new index that the ETF is tracking? But don't just look at the new name of the ETF or the name of the new index because if we take the example of a switch from a core index to an ESG versioned, sometimes a name can be quite generic by adding only a short description of the ESG element into the name. The investor should actually understand what the new index actually is, what the methodology of the new index is, and what kind of ESG exposure the index is focusing on. And then go into what is the strength of the ESG exposure that the index is trying to reflect. For example, it could be a simple exclusion of controversial non-ESG stocks, or it could go to the stronger end of the spectrum by looking at the ESG scores of various stocks and only taking in the stocks with high scores.

So with this, there could be a lot of changes. So I think I would suggest investors to mimic what our analysts would do when assessing an ETF that has a change index when we rate a fund. So basically, which is to reassess the investment merits of the ETF in general by looking at the result of the impact on the portfolio. In particular, how would the diversification change? How would the representativeness change? And by looking at these areas, investors can form a view to see if the new exposure is one that is suitable for themselves and make a decision to continue with the fund or switch to another one. And also, very importantly, to take a look at whether the fees have changed, whether or not it is an increase or decrease.

Lin: Thank you, Jackie. That's very clear. For Morningstar, I'm Kate Lin.