Three Things You Need to Know Before Investing in a Passive ETF

Benchmark definitions

It’s not enough to go by a passive ETF’s name and marketing material – you need to look under the hood and understand how its benchmark index works, particularly its definitions and rules.

Why? So, you get what you’re actually looking for. A great example is the Technology Select Sector SPDR Fund

, which tracks technology stocks in the S&P 500 via the Technology Select Sector Index. But here’s the catch – you won’t get exposure to Tesla, Amazon, Meta Platforms, or Alphabet. Why?

Under the Global Industry Classification Standard (GICS), Tesla and Amazon are classified as consumer discretionary, while Meta and Alphabet fall into communications services. XLK’s index follows this framework, so those companies are excluded, even if you think of them as tech.

This isn’t a one-off issue. Index providers often use varying definitions for sectors, the cutoff points for small-, mid-, and large-cap stocks, or the metrics for assigning growth versus value style labels.

ETF fund managers won’t always spell this out for you, so here’s the takeaway: identify the benchmark index, go to the source (the index provider), download the methodology document, and read it carefully to ensure it aligns with your investment expectations.

Benchmark history

This one is even more insidious, and you’ll need to scroll deep into the fine print to spot it: fund benchmark changes. Always check the benchmark history – it could save you from picking an ETF with misleading performance data.

Take the Vanguard Dividend Appreciation ETF

, for example. Today, it tracks the S&P U.S. Dividend Growers Index. Backtesting its performance shows impressive historical returns.

But there’s a catch – before September 19, 2021, VIG tracked the NASDAQ US Dividend Achievers Select Index (previously called the Dividend Achievers Select Index). Its past performance is tied to that old benchmark, not the one it follows today.

Some ETFs have switched benchmarks multiple times, which makes past performance even harder to trust. The Invesco S&P 500 GARP ETF

is a prime offender here.

Its performance history reflects three benchmarks: the RAFI Fundamental Large Growth Index before May 22, 2015, the Russell Top 200 Pure Growth Index until June 21, 2019, and its current S&P 500 Growth at a Reasonable Price Index.

What does this mean for you? If an ETF has changed its benchmark index, past performance becomes far less reliable for drawing conclusions. This is critical if you’re comparing ETFs or relying on historical backtests to choose between them.

Tracking error

Passive management has become incredibly efficient, and one way to measure its quality is tracking error. Simply put, tracking error is the difference between an ETF’s performance and the benchmark index it’s trying to replicate.

For instance, the Vanguard S&P 500 ETF

has delivered a total return of 13.3% over the last 10 years. Over the same period, the S&P 500 index returned 13.35%. That’s a tracking error of just 0.05% annually – a tight and acceptable margin.

What causes tracking error? Fees play a big role – VOO’s 0.03% expense ratio contributes to the gap. Beyond fees, it comes down to the portfolio management team’s skill and their methods for replication or sampling. Replication means holding every stock in the index at its exact weighting, while sampling involves holding a representative subset to save on costs or improve liquidity.

Tracking error is one area where investors can make apples-to-apples comparisons. If two S&P 500 ETFs have the same fees, the ETF with the smaller tracking error is usually the better choice. It’s a sign the fund manager is doing a more precise job tracking the index.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.