What are the pros and cons of active and passive ETFs?

The funds are tax-efficient and offer investors trading flexibility, portfolio diversification and risk management

Exchange-traded funds are akin to mutual funds, but with superior advantages. Bloomberg

Exchange-traded funds (ETFs) have been popular global investment instrument over the past 30 years.

As the name suggests, ETFs are pooled investment securities that can be bought or sold through a brokerage or an exchange, as is the case for do-it-yourself investors.

They are akin to mutual funds but with superior advantages. They are more tax-efficient and offer trading flexibility while providing portfolio diversification and risk management.

The ETF industry was predominantly perceived as synonymous with plain vanilla index investing until 2008. However, active management has garnered traction in recent years.

Passive ETFs

Passive ETFs are long-term investments that track the performance of an underlying index, sector, or asset class.

As a result, they have a lower expense ratio and lower trading costs because investors do not need to adjust their portfolios frequently.

They are a stable way for investors to quickly achieve their desired risk profile with the index or sector of their choice.

Passive ETFs replicate the holdings of the underlying index – based on clear and sound principles.

Compared to investments such as active ETFs and mutual funds, passive ETFs generate less capital gains distribution, have a lower portfolio turnover and tend to use in-kind redemptions to avoid selling securities at a gain.

Passive ETFs are less flexible because investors cannot make custom changes to their portfolio or adopt defensive strategies if market risk intensifies. This makes it challenging to capture lucrative opportunities or adopt protective measures during a market downturn.

Active ETFs

An active ETF is a cleverly designed investment vehicle that integrates the features of passive ETFs and traditional mutual funds.

Instead of tracking an index, it aims to outperform a benchmark by virtue of active selection and management of constituent securities.

Implementing discretionary strategies that modify exposure to asset classes based on the ever-evolving macroeconomic conditions has enabled asset managers to capitalise on market inefficiencies and mispriced securities to deliver higher returns over time.

On average, active ETFs have a higher annual expense ratio of 0.57 per cent relative to an average of 0.26 per cent for passive ETFs.

This is directed towards conducting comprehensive research and due diligence to generate higher risk-adjusted returns and perform active risk management.

Active ETF managers are bound by law to provide daily disclosures to investors.

While this ensures higher transparency, it hinders an active manager’s ability to adjust holdings and implement investment strategies, some of which could be proprietary, without the risk of giving away their edge to competitors and other traders in the market.

Active ETFs do not necessarily outperform their passively managed counterparts or the underlying index by default. A large portion of the outperformance is dependent on the skill of the asset manager in question.

They are gaining in popularity among investors, particularly in volatile and uncertain market conditions such as those that prevailed for a significant part of 2022.

In such instances, some investors might be inclined to trust a qualified professional with a proven track record to manage their investments for a fee rather than managing risk themselves.

This grants investors access to sophisticated research and trading strategies that may give them an edge over passive investors.

ETF inflows surged to $40 billion in January 2023 alone – nearly double that month’s historical average.

Analysts are projecting active ETFs to gain traction and deliver outsized growth in 2023.

Nevertheless, active ETFs do not necessarily yield higher returns than their passively managed counterparts by default.

This is evident from the mixed performance of dollar-denominated ETFs over the past five years.

For instance, active ETFs fared better in the fixed-income and value equity categories, while passive ETFs emerged victorious over their functional counterparts in specific classes like large-cap and growth equities.

Nevertheless, 31 per cent of actively managed ETFs have outperformed the market so far this year. By comparison, 58 per cent of active ETFs outperformed the market in 2022.

Vijay Valecha is the chief investment officer at Century Financial