Active or Passive Investing in ETFs: An Overview
Traditional exchange-traded funds (ETFs) come in hundreds of varieties, tracking almost any index you can imagine. ETFs offer all the benefits associated with index mutual funds, including low turnover, low cost and broad diversification, plus their expense ratios are significantly lower.
While passive investing is a popular strategy among ETF investors, it’s not the only strategy. Here we explore and compare ETF investment strategies to provide additional insight into how investors are using these innovative instruments.
Key points to remember
- ETFs have grown significantly in popularity over the past decade, providing investors with low-cost access to diversified holdings across multiple indices, sectors and asset classes.
- Passive ETFs tend to follow buy-and-hold index strategies that track a particular benchmark.
- Active ETFs use one of many investment strategies to outperform a benchmark index. Passive holding of an active ETF allows for active management.
- Passive ETFs tend to be cheaper and more transparent than active ETFs, but also don’t leave room for alpha.
ETFs were originally designed to provide investors with a single security that would track an index and trade intraday. Intraday trading allows investors to buy and sell, essentially, all of the securities that make up an entire market (like the S&P 500 or the Nasdaq) in a single transaction. ETFs thus offer the possibility of entering or exiting a position at any time of the day, unlike mutual funds, which only trade once a day.
While the intraday trading capability is certainly a boon for active traders, it’s only a convenience for investors who prefer to buy and hold, which is still a valid and popular strategy – especially if we keep in mind that most actively managed funds fail to beat their benchmarks or passive counterparts, especially over longer time horizons, according to Morningstar. ETFs offer a convenient and inexpensive way to implement indexing or passive management.
Despite the history of indexing, many investors are not content to settle for so-called average returns. Even though they know that a minority of actively managed funds beat the market, they’re willing to give it a try anyway. ETFs are the perfect tool.
By allowing intraday trading, ETFs give these traders the ability to follow market direction and trade accordingly. Although they still trade an index like a passive investor, these active traders can profit from short-term moves. If the S&P 500 rises higher as markets open, active traders can immediately lock in profits.
So all of the active trading strategies that can be used with traditional stocks can also be used with ETFs, such as market timing, sector rotation, short selling and margin buying.
Actively Managed ETFs
Although ETFs are structured to follow an index, they could just as easily be designed to follow a popular investment manager’s top picks, mirror any existing mutual fund, or pursue a particular investment objective. Besides the way they are traded, these ETFs can provide investors/traders with an investment that aims to generate above average returns.
Actively managed ETFs have the potential to benefit mutual fund investors and 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, which will reduce cash flow in and out of the mutual fund, making the portfolio easier to manage and more profitable, increasing the value of the mutual fund for its investors.
Transparency and arbitration
Actively managed ETFs are not as widely available as their creation presents a technical challenge. The main issues facing fund managers all involve a complication of trading, more specifically a complication in the role of arbitrage for ETFs. Because ETFs trade on exchanges, it is possible for price differentials to develop between the price of the ETF’s shares and the price of the underlying securities. This creates an arbitrage opportunity.
If an ETF is trading at a lower value than the value of the underlying stocks, investors can take advantage of this discount by buying shares of the ETF and then cashing them in for in-kind distributions of shares of the stock. underlying. If the ETF is trading at a premium to the value of the underlying stocks, investors can short the ETF and buy stocks in the open market to cover the position.
With index ETFs, arbitrage keeps the price of the ETF close to the value of the underlying stocks. This works because everyone knows the holdings of a given index. Index ETFs have nothing to fear in disclosing their holdings, and price parity serves everyone’s best interests.
The situation would be a little different for an actively managed ETF, where the fund manager would be paid for stock picking. Ideally, these picks should help investors outperform their ETF benchmark.
If the ETF disclosed its holdings frequently enough for arbitrage to take place, there would be no reason to buy the ETF – savvy investors would simply let the fund manager do all the research and then wait for the disclosure of their best ideas. Investors would then buy the underlying securities and avoid paying the fund’s management fees. Therefore, such a scenario does not encourage fund managers to create actively managed ETFs.
In Germany, however, Deutsche Bank’s DWS Investments unit has developed actively managed ETFs that disclose their holdings to institutional investors daily, with a two-day lag. But the information is only shared with the general public after a month. This arrangement gives institutional traders the ability to arbitrage the fund but provides outdated information to the general public.
In the United States, active ETFs have been approved, but must be transparent about their day-to-day holdings. The Securities & Exchange Commission (SEC) denied non-transparent active ETFs in 2015, but is currently evaluating various active ETF models disclosed periodically. The SEC also approved the opening of stock trading without price disclosure on volatile ETF days to avoid the record intraday plunge that occurred in August 2015, when ETF prices fell because trading in the securities halted while trading in ETFs continued.
Active and passive management are legitimate investment strategies frequently used by ETF investors. Although actively managed ETFs managed by professional fund managers are still rare, you can bet that innovative fund management companies are working diligently to overcome the challenges of making this product available worldwide.