However, passive investment fuels what is arguably the most vibrant and active sector of the financial world: exchange-traded funds (ETFs).
What is a passive investment, exactly? At its most basic level, it’s an investment that eliminates human hunches from the decision-making process when it comes to what to acquire and when to own it.
Investors pool their money and provide it to a manager, who chooses assets based on his or her study, intuition, and experience. A ruleset defines an index in a “passive” fund, and that index determines what’s in the fund.
ETFs are mostly passive, but not all. Similarly, while active management is frequently associated with mutual funds, passive mutual funds do exist.
So, what does it mean to be invested in a passive manner? In a nutshell, passive investing entails owning the market rather than attempting to outperform it.
In proportion to its magnitude, owning the market just means owning a small piece of everything. A good example is a tracker fund that tracks the MSCI World Index. The fund makes no attempt to predict which stocks will outperform others. Rather, it invests in all equities, with higher investments in larger companies and lower stakes in smaller companies.
Why wouldn’t you want to outperform rather than follow the market? Traditional passive investors feel that consistently beating the market is impossible or, at best, extremely implausible.
Active managers, on the other hand, believe they can outperform the market by picking good stocks and avoiding bad ones.
On the surface, the active argument’s flaw is obvious: there’s no way all active fund managers can beat the market because they’re all the market. In an ideal world, half of these managers would underperform the market while the other half would outperform it.
The issue is that all of these executives want to be compensated. Furthermore, in order to outperform, they incur high transaction fees while buying and selling equities. After fees and expenses, research show that the vast majority of investors outperform the market over time.
That difficulty is solved by passive investment. Index funds are both inexpensive to administer and to own. These “passive funds” outperform most active managers over time by capturing the market’s return at the lowest possible cost.
While we’re focusing on equities indexes in this article, passive investing may be used in any market and asset class, from corporate high-yield bonds to agricultural commodities.
The vast array of markets that passive funds can access hints at perhaps the most difficult decision that all investors, whether passive or active, must make: how much money to put in certain asset classes. Many think that the most important decision is allocation, and that it has a greater impact on risk and return in a portfolio than security selection. Passive investing allows investors to concentrate on this important component without the distraction and cost of picking particular stocks within an asset class.
Passive tools are used by some of today’s most aggressive macro-oriented investors to make active asset allocation decisions.
In short, passive investing is anything but passive (or uninteresting or lazy). Many of the most essential decisions, such as asset allocation and picking the right passive vehicle for the job at hand, are still to be made.
While the evidence shows that active managers struggle to outperform the market after costs, there are areas of the market where active investing can be justified. Fixed income, for example, is known for being a notoriously opaque and illiquid market. There is no central exchange for trading fixed-income instruments, unlike equities, and many fixed-income securities do not trade as often as stocks. Fixed-income instruments do not have a central pricing mechanism as a result. The further you get away from national debt, the more prominent this gets. There is substantially less price unanimity until you get into municipals, junk bonds, senior loans, or adjustable rate assets.
As a result, the assumption that stronger managers and analysis might yield outperformance in these markets has some merit. Furthermore, value weighting is a neutral weighting mechanism in fixed income, in which the bonds with the highest outstanding face value obtain the highest index weighting. This means that the largest borrowers are given the most weight. Active managers can avoid this problem by selecting higher-quality credits using their own own fundamental analysis.
These are, however, the exception rather than the rule. True outperformance is transitory, not long-lasting, according to history. Managers who outperform one year are usually underperformers the following year. Passive investing is a cost-effective and efficient way to capture the market.
What is the difference between active and passive ETFs?
Since 1993, when State Street launched the SPDR S&P 500 ETF in the United States, passive ETFs have existed. Passive ETFs follow an index (such as the S&P 500 index), and the portfolio is adjusted on a regular basis (usually quarterly) to reflect changes in the reference index.
Active ETFs, in which a portfolio of assets is actively managed by an investment manager, have been around for a while. However, investors have had few options because investment managers have been hesitant to expose their portfolios on a daily basis. In early 2015, issuers and regulators in Australia reached an agreement on a portfolio disclosure system that matched the needs of investors who want to know what they’re investing in with the protection of the investment manager’s intellectual property (its portfolio holdings an active portfolio decisions).
Passive ETFs and Active ETFs are structurally similar, but they have several key differences that investors should be aware of.
WHAT ARE THE SIMILARITIES?
Both passive and active ETFs are normally registered managed investment plans in Australia, a form of ‘unit trust’ that trades on the ASX in the same way that a company’s stock does. Investors can purchase and sell units in the ETF from each other on the ASX, just like any other share or unit traded on the exchange.
ETF issuers put in place extra liquidity mechanisms to promote effective trading in the secondary market of ETF units, with the goal of having the trading price follow the underlying net asset value. ETFs are able to accommodate these liquidity agreements because they are open-ended funds that can constantly issue and redeem units.
The provision of liquidity for passive ETFs is usually delegated to third-party market makers such as investment banks. Market makers trade an inventory of units on the ASX and can apply or redeem their net trading position with the ETF. These market makers develop their own opinion of the ETF’s net asset value and place bids and offers in the market around that value, all while staying within their own balance sheet risk appetite for providing liquidity.
Active ETF issuers can choose to use the same market-making mechanism as passive ETFs or have the ETF supply liquidity. This means that the ETF may provide bids and offers in the market at any moment based on the issuer’s current assessed worth of the units.
Regular disclosure published on the ASX and the ETF issuer’s website provides investors with transparency into the value of the underlying fund and the composition of its portfolio. The net asset value per unit and an indicative intraday net asset value (iNAV) per unit, which normally updated during the ASX trading day, are used to calculate the value of the ETF’s underlying investments. The level of portfolio disclosure will vary depending on whether the ETF is a Passive ETF or an Active ETF, as well as what has been negotiated with the ASX in the case of the latter. Passive ETFs will either provide an iNAV per unit or the entire portfolio, including investment names and weights, as well as monthly fund data sheets. On a monthly or quarterly basis, active ETFs will typically publish daily net asset value and iNAV per unit, monthly fund fact sheets, and a comprehensive portfolio containing the names and weights of the investments.
Both Passive and Active ETFs, like unit trusts, offer a full pass-through of income such as dividends, franking credits, capital gains, and discounted capital gains income, allowing investors to manage their own tax affairs.
WHAT ARE THE DIFFERENCES?
A portfolio manager for an Active ETF will do stock research to decide which underlying securities or stocks to hold and in what proportions. They will then actively manage stock weightings based on stock prices, industry trends, and macroeconomic views. They can also have cash on hand to control the portfolio’s overall risk and to take advantage of market opportunities.
A passive exchange-traded fund (ETF) tracks an index. This could be done using a wide stock market index, a sector index, custom-built indices, or indices that include fixed income, credit, commodities, and currency. They can either fully replicate an index by purchasing all of the index’s securities, or they can optimize an index by purchasing stocks in an index that provide the most representative sample of the index based on correlations, exposure, and risk. Physical ETFs attempt to track their target indices by holding all or a representative sample of the underlying securities that make up the index, whereas synthetic ETFs execute their investment strategy using derivatives such as swaps rather than physically holding each of the securities in an index.
HOW MANY ETFS ARE AVAILABLE ON THE ASX?
On the ASX, there were 185 active and passive ETFs with over $41 billion in assets under management as of the end of January 2019.
HOW DO I ACCESS ETFS?
Passive and Active ETFs are available on the ASX through your online share trading account or through your stockbroker. You’ll need to know the ASX code for the ETF you’re interested in.
Is it possible to actively manage an ETF?
ETFs and mutual funds can help you establish a diverse investing portfolio. Different types of ETFs have emerged as the ETF market has matured. They can be managed in two ways: passively or actively. Actively managed ETFs aim to outperform a benchmark (such as the S&P 500). Passively managed ETFs strive to closely match a benchmark (such as a broad stock market index).
Traditional actively managed ETFs and the newly allowed semi-transparent active equities ETFs are the two types of actively managed ETFs. Let’s take a closer look at classic actively managed exchange-traded funds (ETFs).
What is an active exchange-traded fund (ETF)?
An actively managed ETF is a type of exchange-traded fund in which the underlying portfolio allocation is decided by a manager or team, rather than following a passive investment strategy.
Although an actively managed ETF will have a benchmark index, managers can adjust sector allocations, make market-time trades, and diverge from the index as they see suitable. This results in investment returns that aren’t exactly the same as the underlying index.
What are passive exchange-traded funds (ETFs)?
A passive exchange-traded fund (ETF) is a financial instrument that attempts to replicate the performance of the stock market as a whole, or of a specific sector or trend. Passive ETFs track the holdings of a designated index, which is a collection of tradable assets that is thought to represent a specific market or segment. Passive ETFs can be bought and sold at any time during the trading day, just like stocks on a major exchange.
Do all ETFs follow the same index?
Index ETFs, like other exchange traded products, provide quick diversification in a tax-efficient and low-cost investment. A broad-based index ETF also has fewer drawbacks than a strategy-specific fund, such as lower volatility, tighter bid-ask spreads (allowing orders to be filled quickly and effectively), and favorable cost structures.
Of course, no investment is risk-free. Index ETFs do not always properly reflect the underlying asset and can fluctuate by up to a percentage point at any given time. Before making an investment, investors should think about asset fees, liquidity, and tracking error, among other things.
How can I get an active ETF going?
How do you get started with an exchange-traded fund (ETF)? The procedure for launching an ETF is similar to that of launching an open-end mutual fund. A new fund can be added to an existing series trust as an additional series ETF or created as the first ETF in a new trust.
How many ETFs are currently active?
Only 50 active ETFs have gathered more than $1 billion in assets, with fixed-income funds accounting for more than half of those. (Active management for ETFs was adopted by fixed-income managers years ago.)
How can you know if an ETF is managed actively?
An index fund or an ETF are both examples of passively managed funds. In addition, the summary overview of a fund will state whether it is an index fund or an exchange-traded fund (ETF). If it doesn’t, it’s safe to think it’s being actively managed. For example, Vanguard’s REIT ETF (VNQ) declares that it is an ETF and that it invests in REITs.
The goal is to closely replicate the MSCI US Investable Market Real Estate 25/50 Index’s performance.
There are some slight variations between ETFs and index funds when it comes to investing. The most significant difference is that ETFs trade on the stock exchange throughout the trading day, whereas index fund transactions, like other mutual funds, take place at the conclusion of the trading day. Many online brokers offer commission-free ETF trading for a variety of ETFs, and the expense ratios of index funds and ETFs offered by the same provider are quite comparable, if not identical. Some index funds have high minimum opening deposits, making their ETF equivalents more accessible.
Simply look through the company’s list of ETFs or index funds to see which are on the list to discover if your funds are actively or passively managed. Vanguard has the lowest management expense ratios (and why not go with the cheapest if you’re going with a passively managed fund that tracks an index?). Here are a couple of places to begin:
Unfortunately, actively managed funds still account for a big portion of invested assets (at the price of investor performance), but you now have the knowledge to help alter that!
Index ETFs Are Passive Investing Vehicles
Index ETFs are designed to track the performance of a specific index. In general, active ETFs attempt to outperform a benchmark index.
Index ETFs are passive investment instruments that rely nearly exclusively on the performance of an underlying market index. To track the index and replicate its performance, fund managers buy and sell assets.
Market indexes are used as benchmarks in active ETFs. Rather than trying to replicate or follow the performance of a specific index, they endeavor to outperform it. Although outperforming an index over the long term is difficult, if an active ETF’s fund manager plays their cards well, investors may see higher returns.
Index ETFs Have Lower Costs
The lower expense ratios of index ETFs are a significant benefit. While paying a higher expense ratio may make sense if you’re looking for a fund with a specific strategy, index funds tend to provide higher average returns with lower average costs over time.
While a 0.50 percent difference may appear insignificant, it can add up to tens of thousands of dollars over the years. For example, if you invested $6,000 per year for 30 years and had 6% average annual returns, an active ETF charging the average fee would cost you $44,000 more than an equity index ETF.
Active ETFs Respond to Current Events
The capacity of actively managed ETFs to adjust to quickly shifting markets is a significant benefit.
“Index funds are built on the status quo at a time when the economy and the way we operate are fast changing,” Meadows explains. “Some companies could be deleted from an index for a year or more before the changes are reflected in an index ETF.”
Active portfolio managers alter their holdings as often as necessary, allowing them to quickly replace companies whose stock prices have been slashed by recent events. Some investors may find this type of responsiveness appealing.
Index Funds Offer Stable Long-Term Returns
According to S&P Global, more than 87 percent of actively managed funds have underperformed their benchmarks over the last 15 years. The S&P 500 had an average yearly return of 8.9% with dividends reinvested throughout the same time period, which includes the Great Recession.
According to Berlinda Liu, head of Global Research & Design at S&P Dow Jones Indices, actively managed funds have underperformed benchmark performance even in 2020, a year characterised by volatility and economic instability.
However, not all actively managed ETFs strive to exceed benchmarks; some just seek to provide good returns of some kind, regardless of market conditions.