Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 274

Active or passive ETFs: how do you decide?

Working for an Exchange Traded Fund (ETF) manager, investors might presume that I’ll always favour a simple passive index-tracking ETF. Whilst I may think that indexing is the way to go most of the time because of the instant diversification, lower costs, and the historical inability of the majority of active managers to outperform their benchmarks, active strategies have their role in portfolios.

However, as an investor, how do you decide which approach to use?

The evolution of ETFs

Exchange traded products have gone through an evolution over the years like products in other industries:

  1. At first there were passive index-tracking ETFs which seek to mirror the performance of a specific investment index, and which often utilise a simple market-cap weighted methodology or aim to track a specific commodity or currency, or group of commodities and currencies.

  1. Then came smart beta or rules-based exchange traded products, typically using a systematic investment approach. Some of these approaches can still be index tracking. However, such indices typically go beyond market-cap weighted methodologies and may consider factors like size, value and volatility as an alternative weighting methodology. Other products may not track an index but still use a prescriptive set of rules as part of their investment objectives (for example, yield-oriented buy-write strategies or funds that aim to provide short exposure to share markets).

  1. More recently, active ETFs have portfolio managers making decisions on the underlying portfolio composition and do not try to mirror the performance of any underlying index. Instead, typically the manager’s main goal is to outperform a benchmark index by actively trading or changing sector allocations.

What should an investor take into consideration when deciding whether to select active or passive investment strategies? Here are three considerations:

1. How efficient is the underlying market?

There are segments of the market that are inefficient, giving an opportunity to exploit mis-pricing and potentially deliver outperformance, or ‘alpha’. Active management or smart beta, rules-based strategies may do better. Two examples are hybrids and small cap markets.

In hybrids, an active manager can potentially add value over an index-tracking approach by accessing deeper liquidity and improved trading costs, with specialist knowledge to assess the complex and varied issuance terms of securities, and the ability to sell securities when they become overvalued.

In small caps, we believe that most of the outperformance in the sector can be achieved over market cycles, by identifying and avoiding companies with undesirable investment characteristics. This can be achieved with some sensible screens, delivered in a cost-effective way via an exchange traded product.

2. Where are we in the market cycle?

When a momentum-driven market is generally moving higher, there may be no need to look at active or smart beta strategies. “A rising tide lifts all boats” is the saying, and just having exposure to the right sector may be all that is needed.

However, as a market peaks and corrects, market pull backs and risks may be mitigated by using a strategy that is active or rules-based, which will hopefully have exposure to higher quality securities that will be less affected by the fall.

High volatility or trendless markets present another opportunity for active and smart beta strategies to take advantage of specific securities or sectors. Or alternative strategies that are defensive, or not as correlated to rest of the market, can also shine.

Yield strategies have always been popular with Australian investors. A few years ago, most yield stocks performed well. The market environment is different today. Banks may struggle to grow their earnings and therefore their share prices in the years ahead. There is some prospect that interest rates could rise again, which would impact interest rate sensitive investments, and many market observers feel the top 20 stocks on the ASX will have a more difficult time.

For funds with a specific income objective, active management can add value above a passive strategy by navigating the markets in changed market conditions. Specific strategies aim to deliver an attractive, tax-effective and low volatility income stream that can increase with inflation, targeted at retirees and low-tax paying investors.

3. Is the added cost for active or rules-based strategies worth the money?

Shopping for any product is about value. A top quality shirt may cost more but with longer wear, it might cost less in the long run. The same goes for investing. Will there be enough outperformance in the long term to justify the added cost? Management fees eat into returns and, although an active manager may outperform their benchmark, after considering their fees may underperform.

The cheapest Aussie equities exposure in the world is currently the BetaShares Australia 200 ETF (ASX:A200), with a management fee of 0.07% per annum. However, this is a market cap-weighted index and potential outperformance may come from a smart beta approach such as Fundamental Indexing. It is also available via an ETF and has outperformed the market cap-weighted index over the long term by about 2% per annum*, but with higher fees.

In summary, active, rules-based and passive strategies can be used in conjunction with one another and should be considered as part of a diversified portfolio.

 

*Source: Bloomberg. FTSE RAFI Australia 200 Index v S&P/ASX 200 Index, 1992 to June 2018. Does not take into account ETF fees and expenses. You can’t invest directly in an index. Past performance is not indicative of future returns.

 

Justin Arzadon is a senior member of the Distribution team at BetaShares, a sponsor of Cuffelinks. This material has been prepared as general information only, without reference to your objectives, financial situation or needs. You should seek your own financial advice before making any investment decision.

For more articles and papers from BetaShares, please click here.


 

Leave a Comment:

RELATED ARTICLES

The challenges of building a lazy portfolio

Global ETFs: insights into a multi-trillion-dollar industry

Australian ETFs: end of year reviews 2018

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Shares

Exploiting Warren Buffett

Growth investors are using Buffett to justify buying blue chip stocks at almost any price. It’s a recipe for potential disaster, as investors in market darlings like CBA and Cochlear may be about to find out.

Property

Population density trends and what they mean for housing

With Australia’s population moving through the fastest rate of growth since the 1950s, our cities and towns are naturally densifying. This is a look at the latest trends and how they will impact the property market.

SMSF strategies

The ultimate superannuation EOFY checklist 2024

We're nearing the end of the financial year and it's time for SMSFs and other super funds to make the most of the strategies available to them. Here's a 24-point checklist of the most important issues to address.

Shares

The outlook for Nvidia, from a long-time investor

Nvidia has taken the world by storm and is now the third largest stock on the planet - larger than Meta, Amazon, and Alphabet. Here is the latest take on Nvidia from a fund manager who first invested in the company in 2016.

Economy

Gross National Happiness?

Despite being richer, surveyed measures of happiness have been flat to falling in Australia. Some suggest we should focus less on GDP and more on broader measures of wellbeing, though there are pros and cons to that approach.

Shares

The power of dividends

In an era where growth companies dominate and the likes of Nvidia grab all of the attention, dividend paying stocks are flying under the radar. Some of these stocks offer compelling prospective returns.

Fixed interest

The best opportunities in fixed income right now

After more than a decade of pitiful yields, bonds are back offering better prospects for income investors. What are the best ways to take advantage of the market inefficiencies in Australian fixed income?

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.