Active or passive ETFs: how do you decide?

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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.

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