Active vs. Passive ETF Investing: An Overview
Exchange-traded funds (ETFs) first started trading in the United States in the 1990s. Today, they are available in hundreds of varieties, tracking nearly every index you can imagine.
ETFscan offer all of the benefits associated with index mutual funds, including low turnover, low cost, and broad diversification. In addition, the expense ratios of passively-managed ETFs can be lower than those for similar mutual funds.
Passive ETF investing is a popular strategy among investors who prefer a long-term, buy-and-hold approach to investing their money. On the other hand, active ETF investing, which involves fund managers actively trading securities within an ETF to outperform an index, is an alternate route that many investors may choose.
Here we explore ETF investment strategies to provide insight that may help you in your investment decision-making.
Key Takeaways
- Exchange-traded funds have grown in popularity since their introduction in the 1990s.
- ETFs provide investors with low-cost access to diversified holdings across broad markets, sectors, and asset classes.
- Passive ETFs tend to follow buy-and-hold strategies to try to track a particular benchmark.
- Active ETFs utilize a portfolio manager's investment strategy to try outperform a benchmark.
- Passive ETFs tend to be lower-cost and more transparent than active ETFs, but do not provide any room for outperformance (alpha).
Passive ETF Investing
Passive investing is an approach to investing that focuses on tracking and achieving the return of a specific index. It involves limited transactions. In fact, ETFs were originally constructed to provide investors with a single security composed of many assets that simply would track indexes.
For example, some passive ETFs track the S&P 500 index or the Nasdaq. This means investors gain exposure to the entire markets represented by these indexes.
Therefore, the fund manager of a passive ETF isn't making allocation decisions or conducting trades beyond those that take place in the index itself.
Thus, passive ETF investing provides a convenient and low-cost way to implement indexing or passive investment management. This is especially attractive to those investors who wish to buy and hold securities (rather than engage in trading them) for the long-term.
Intraday Trading
ETFs also trade throughout the day just like individual stocks. This intraday trading allows investors and active traders to buy and sell ETFs at their discretion, unlike mutual funds, which trade only once per day.
While the ability to trade throughout the day can be a boon for certain investors, such trading can result in unnecessary transaction costs. Those costs can affect investor returns. That is a fundamental difference between the strategies of passive and active ETF investing.
According toMorningstar, mostactively managedfunds fail to beat their benchmarks or passive ETF counterparts, especially over longer time horizons.
Before investing in any ETF, be sure to read its summary prospectus. This document, along with the full prospectus, provides all details about the fund that investors should know, including its investment strategy, costs, and risks.
Active ETF Investing
Trading a Passively Managed ETF
Despite indexing's ability to achieve the returns represented by indexes, many investors aren't content to settle for so-called average returns.
Even though they may know that a minority of actively managed funds beat the market, many are still willing to try active investing using their passively managed ETFs. That is, they'll trade their ETF to attempt to track short-term market movements. If the S&P 500 races upward when the markets open, active traders can lock in the profits immediately by selling their ETF.
Importantly, all of the active trading strategies that can be used with traditional stocks can also be used with ETFs, such asmarket timing, sector rotation, short selling, and buying on margin.
Actively Managed ETFs
Actively managed ETFs differ from the concept of passively managed ETFs that are actively traded by investors (as described above).
Actively managed ETFs involve a fund manager or management team that researches investment opportunities and actively selects the ETF's portfolio securities and allocation, according to the investment goals that they seek to reach.
These ETFs can provide investors/traders with an investment that aims to deliver above-average returns.
Actively managed ETFs have the potential to benefit mutual fund investors and fund managers as well. If an ETF is designed to mirror a particular mutual fund, the intraday trading capability will encourage frequent traders to use the ETF instead of the fund.
This will reduce cash flow in and out of the mutual fund, making that portfolio easier to manage and more cost-effective. In turn, this can enhance the mutual fund's value for its investors.
Transparency and Arbitrage
Actively managed ETFs are not as widely available as index ETFs because there is a technical challenge in creating them. This involves a trading complication related to the role of arbitrage.
Because ETFs trade on a stock exchange, there is the potential for price disparities to develop between the trading price of the ETF shares and the trading price of the underlying securities. This creates the opportunity for arbitrage.
If an ETF is trading at a value lower than the value of the underlying shares, investors can profit from that discount by buying shares of the ETF and then cashing them in for in-kind distributions of shares of the underlying stock.
If the ETF is trading at a premium to the value of the underlying shares, investors can short the ETF and purchase shares of stock on the open market to cover the position.
With index ETFs, arbitrage keeps the price of the ETF close to the value of the underlying shares in the index. This works because the holdings in a given index are known. Investors in index ETFs have nothing to fear from the disclosure of their holdings. Price parity serves everyone's best interests.
The Challenge of Disclosing Holdings
The situation is different for an actively managed ETF whose money manager gets paid for stock selection. Ideally, those selections are made to help investors outperform the ETF benchmark index. If the ETF disclosed its holdings frequently enough so that arbitrage could take place, there'd be no reason to buy the ETF.
Smart investors would simply let the fund manager do all of the research and then wait for the disclosure of their best ideas. The investors would then buy the underlying securities and avoid paying the fund's management expenses. Therefore, such a scenario provides no incentive for money managers to create actively managed ETFs.
SEC Allows Non-Disclosure
Up until 2019 in the U.S., actively managed ETFs were required to be transparent about their daily holdings. However, in 2019, the Securities & Exchange Commission (SEC) approved the practice of non-transparency (not disclosing holdings each day). As a result, actively managed ETFs that don't disclose holdings daily are required to make clear to investors the lack of transparency and the risks involved.
The SEC has also approved opening stock trading without price disclosures on volatile days. This is due to the record intraday drop that occurred in August 2015, when ETFsprices dipped because securities' trading halted while ETF trading continued.
Passive ETFs will often have lower management fees compared to actively managed ETFs.
Portfolio Management Fees
Active ETFs tend to have higher management expenses compared to passive ETFs. As discussed earlier, this is because the fund's assets are selected and overseen by a portfolio manager who is making active investment decisions in an attempt to outperform the benchmark index.
The fees for active ETFs typically cover the costs associated with research, trading, security selection, and ongoing management of the portfolio.
Passive ETFs are known for their cost-efficiency, and they generally have lower management fees. The primary objective of passive ETFs is to replicate the performance of a specific benchmark index or asset class without requiring active decision-making.
Since there is no active manager trying to beat a benchmark, there is also often less of an administrative fee. This is because most passive ETFs rely on a rules-based approach that doesn't involve the ongoing costs associated with active research or security selection.
Performance Expectations
Active ETFs
Investors in active ETFs have performance expectations that are tied to the skills and expertise of the portfolio managers. The fundamental premise of active management is to generate alpha, which represents returns above and beyond the benchmark index.
These managers seek to identify undervalued or overvalued assets, make strategic asset allocations, and time the market to capitalize on opportunities and mitigate risks. In many ways, active ETFs create greater opportunities to deviate from standard market returns.
Passive ETFs
In contrast, passive ETFs have a very different set of performance expectations. The primary objective of passive management is to replicate the performance of a specific benchmark index, allowing investors to participate in the overall market or a specific asset class.
Therefore, investors in passive ETFs can expect returns that closely mirror the returns of the chosen benchmark without the performance expectation of beating that index.
It's important understand that passive ETFs aim to minimize tracking error, the deviation between the ETF's returns and the benchmark index's returns. Therefore, the basis for evaluating a passive ETF's performance may not necessarily be the annual return it yields but how closely it mirrored the index it is trying to mimic.
What Types of Indexes Do Passive ETFs Typically Track?
Passive ETFs can track a wide variety of assets and indexes, including equity indexes (e.g., S&P 500, NASDAQ), fixed-income indexes (e.g., Barclays Aggregate Bond Index), commodity indexes (e.g., gold, oil), and more. This flexibility allows investors to gain exposure to specific markets or asset classes without needing to invest in specific stocks directly.
What Are the Risks Associated With Investing in Passive ETFs?
There are several types of risk related to passive ETFs. Market risk refers to the risk that the underlying benchmark index performs poorly, which can impact the returns of the ETF. Tracking risk is the risk that the ETF's returns deviate from the index's returns due to factors like expenses, trading costs, and tracking error. Liquidity risk is the situation where trading in an ETF is thin, making it hard to sell your ETF when you wish to.
What Are the Potential Drawbacks of Active ETFs?
Active ETFs are often more expensive to hold, due to the costs associated with active research, trading, and decision-making. Additionally, the active management approach means that investors are reliant on the expertise of portfolio managers, and there's no guarantee of outperformance. Some active ETFs may underperform or incur losses when passive benchmarking EFTs may achieve gains.
How Do Active ETFs Select and Manage Their Investment Portfolios?
Active ETFs employ professional portfolio managers who make investment decisions about the securities in the fund. These managers use their expertise, research, and market insights to select securities, allocate assets, and adjust the portfolio based on market conditions and their investment strategy.
The Bottom Line
Active and passive management are legitimate and frequently used investment strategies sought by ETF investors.
As an investor, if you prefer a long-term, buy-and-hold approach to building wealth, then passive ETF investing may be right for you.
Alternatively, if you seek the potential for returns that outpace those offered by the broad market and other indexes, then you may wish to consider and include active ETFs in your portfolio.
