What are actively managed ETFs and passively managed ETFs? Advantages and Disadvantages
Active ETFs and Passive ETFs the words actively and passively convey a meaning that has a positive and a negative connotation.
However, in the parlance of ETFs, it is not the case. In the point of ETFs, sometimes being passive rather than active can help.
In this article, let’s try to understand what they stand for and how one stands against the other, or are they just different investment strategies?
What is Passively managed ETFs?
Passively managed ETFs are the ETFs that directly replicate the underlying index. The investment strategies of the ETF are governed by the underlying index and not the conscience of the fund manager.
Let’s understand with an example, the Vanguard S&P 500 ETF (VOO) is a passive ETF that tracks the S&P500. The ETF has 507 shares in it, and the index has 505. The standard deviation is 17.42% and 17.41%, respectively, thus, showing shows how closely the ETF tracks the index.
Passive investment means moving along the market, i.e., owning it rather than outpacing it. Owning the market means having a portion of all the underlying index shares and mimicking its growth rather than running ahead.
Conservative passive investors feel that consistently beating the market is impossible or, at best, extremely implausible.
Passive funds are cheaper to own and administer, and this lowers the expense ratio of the ETF. In our above example, the Vanguard ETF has a meagre expense ratio of 0.03%. Most passive investors believe that these funds outperform the actively managed funds in the long run due to lower costs, and not all can be above average.
However, not everything is excellent; passive investing comes with problems and criticisms. Passive ETFs are subject to market risks and lack flexibility. The fund managers are helpless if the index goes against the ETF strategy, and they cannot alter the underlying assets to cushion such volatility.
One of the most significant drawbacks of these ETFs is that they track capitalization-based indices. The larger the market capitalization of a stock, the higher its weight in the index and consequently in the ETF.
This reduces the diversification of the ETFs and makes the ETF returns susceptible to the performance of such large-cap firms.
What are Actively managed ETFs?
An actively managed ETF is a type of exchange-traded fund. A manager (or a team) chooses the underlying portfolio allocation rather than an index or a rule. Active ETFs generally try to outperform a specific benchmark or a sector.
The managers are free to select any strategy to deliver the promised gains to the investors.
The ETF has an underlying benchmark index, but the manager can alter the allocation of the securities as the manager sees fit – thereby generating a return that does not mimic the index.
Let’s understand with the help of an example. The SPDR SSGA Global Allocation ETF (GAL) has an allocation in various stocks, bonds and ETFs spanning several sectors of the economy and the globe. The ETF also has exposure to corporate bonds, emerging markets and small-cap stocks.
An actively managed ETF allows the investor to course-correct during market volatility and provides a pioneering solution to asset management.
Such strategies are also common in mutual funds, but they become an attractive option since ETFs have lower costs than mutual funds. The GAL ETF has an expanse ratio of just 0.35%.
However, the active managed ETFs also have several drawbacks. Active ETF fund managers have the option to trade outside of a benchmark index, making it more difficult for investors to predict the composition of their future portfolios. Such ETFs have a higher expense ratio than the traditional passive ETFs.
In our examples, the expense ratio of both these ETFs differed by almost 0.32%. The pressure to beat the market might hamper asset allocation, and the ETF might underperform the actual index.
Most fund managers adjust budgets based on market conditions; the fund may become less diversified than a passive ETF.
Actively managed ETFs and passively managed ETFs is an effective and popular investment technique for ETF investors.
Data from 2017 to 2020 shows that the number of actively managed ETFs is falling, and passive ETFs are increasing.
A new form of investment strategy called Smart Beta is also cropping up, which we will discuss in the coming time.