Unsung heroes

Portfolio managers are an often underappreciated part of the ETF industry but they play a crucial role in ensuring an ETF tracks its index as tightly as possible. Where ETF portfolio managers show their value, in particular, is around index rebalance dates when an ETF must adjust their holdings in order to continue to mirror its underlying index. 

If the S&P 500, for example, announces plans to delete a stock from the index then an S&P 500 ETF will do the same in order to minimise tracking error. Following the dramatic rise of passive investing in recent decades, there are now vast assets attached to many index rebalances such as the S&P 500 which is tracked by over $5trn passive assets. 

Rebalance days

This means when it is time to rebalance, traders can take advantage of the crowding that will be in certain stocks. To counteract this, if the price of a security is moving significantly prior to the rebalance date, however, ETF portfolio managers are not required to execute at the market close on the rebalance date. 

This is portfolio managers' crucial role in ensuring an ETF does not suffer high transaction costs. They can either execute the rebalance before, during or after the date. While this does risk increasing the tracking error of the ETF versus the underlying index – for example, if a security jumps significantly in price – it also protects ETF investors from traders looking to capitalise on the swathe of assets impacting the price of a security when entering or leaving an index. 

When designing an index, a provider may select a rebalance date that is different to the mainstream indices in order to avoid unnecessary volatility. S&P Dow Jones Indices (SPDJI), for example, rebalances indices on the third Friday at the end of each calendar quarter while MSCI indices rebalance on the final business day of February, May, August and November. 

There is also a trade-off with rebalance frequency. Taking the momentum factor as an example, an index must rebalance frequently enough to ensure it is offering exposure to stocks that show genuine momentum, however, too much rebalancing increases the trading costs for investors. 

Fixed income nuances

In the fixed income space, rebalances are more frequent in order to account for new bond issuance, rating changes, coupon payments, principal paydowns and bonds with maturities that no longer fit the requirements of the index’s rules, according to BlackRock. 

To offset potential transaction costs from frequent rebalancing, an ETF portfolio manager can invest in bonds before the rebalance date such as taking part in new issues.

ETF portfolio managers are certainly not the star fund managers of the active mutual fund world, however, their role in ensuring ETFs trade as efficiently as possible during scheduled rebalances and periods of market stress should not be underestimated.