Active Versus Passive—What’s Your Strategy?

35593940_sI often joke with folks about all of the abbreviations in the financial industry. IRA, RIA, FIA, VA, IUL, PFS, CFP, CPA; it’s crazy. Sometimes it sounds like a really disturbing spelling bee. I know it can be hard to keep track of them all, or even remember what they all stand for, but I’m going to throw one more at you that is important to understand: ETF.
Exchange Traded Funds (ETFs) are investment vehicles traditionally designed to track an index, such as the S&P 500. They are nearly endless in the specific indices they track and at their core, ETFs provide the main benefit of mutual funds, diversification. However, the expense ratios of ETFs tend to be significantly lower than that of mutual funds.
An even bigger difference between ETFs and mutual funds is the ability to get in or out of an ETF at any time throughout the day, giving the investor increased liquidity and control. Mutual funds, on the other hand, trade only once per day.
ETFs have been a common investment solution for years, but there’s reason to take special notice of them now. In the past, many ETFs have been considered “passive” in that they were originally constructed to provide a single security that tracks an index and trades intraday. This capability lends itself to that pesky buy-and-hold strategy that I’ve warned against. However, a relatively new investment solution is the Actively Managed ETF. Actively Managed ETFs grew 2.8 percent in April to a little over $20 billion in assets, the first time that the Actively Managed ETF space has surpassed the $20 billion threshold. In fact, in the last year, Actively Managed ETFs have grown 28 percent.
So what’s the difference between traditional ETFs and Actively Managed ETFs? It’s right there in the name.
An Actively Managed ETF differs from a regular ETF in that the basket of stocks does not passively track a market index or a custom, rules-based benchmark. A portfolio manager oversees a basket of equities and has the discretion to manage the fund how he or she sees fit. Actively managed ETFs do not subscribe to the buy-and-hold strategy that can result in significant hits to a portfolio like so many suffered in 2002 and 2008. Yet, Actively Managed ETFs still have many of the key perks of traditional ETFs, like intraday trading and tax efficiency. You see, all ETFs are inherently tax-efficient. When an individual investor wants to sell an ETF, he simply sells it to another investor, like a stock. On the other hand, a mutual fund must sell securities to raise cash to meet a redemption, which results in a capital gain or loss for the mutual fund. In fact, ETF.com says that between 2001 and 2011 the average emerging markets equity mutual fund paid out 6.46 percent of their net asset value in capital gains to shareholders, every year, whereas the average emerging market ETF paid out .01 percent over the same time.
But what does that mean for an ETF manager to have the discretion to trade when he or she sees fit? With active management an ETF may deviate from its benchmark index, which could give that ETF a competitive edge over a passive ETF mirroring the same benchmark index. Actively Managed ETFs can take advantage of opportunities that result from short-term market movements. Many of the same tactics used with market trading can be used by managers of Actively Managed ETFs, such as market timing, sector rotation, short-selling and buying on margin.
But just as with any investment strategy rising in popularity, Actively Managed ETFs are not without their challenges, the biggest one being their transparency. ETFs are only required to disclose their holdings once daily, even though their holdings may change multiple times throughout the day. Therefore, investors do not always have access to “real-time” holdings information.
When it comes to actively managed ETFs, my signature advice applies: there is no such thing as a good or bad investment, simply appropriate or inappropriate. Actively Managed ETFs may or may not be advantageous for your strategy, but more and more people are finding them to be worth a second look. And remember, one of the most important threads of information I teach folks is that you must have a strategy, so what is yours?
Be vigilant and stay alert, because you deserve more.