Active ETFs can help your portfolio outperform, but are pricier

Investors have rushed to buy Exchange Traded Funds in recent years because of their low cost structure and easy approach to investing.

One of the main benefits of ETFs is that they expose investors to the returns of major indices and allow investors to sit back and relax.

But that’s not the whole story for ETFs. While most are passive investments, ETFs can also be actively managed.

Alex Campbell, head of communications at investment platform Freetrade, explains: “In recent years, we’ve seen a new type of exchange traded fund emerge that gives investors exposure to a fund that seeks to outperform an index, not just a passive one. index follows. .’

Monika Calay, Director of Passive Strategy Research at Morningstar, said: “While active ETFs are gradually gaining their place in the overall ETF market, they currently occupy a relatively small role, with approximately 370 active ETFs based in Europe.

There are differences between these types of investments which we will discuss below.

Passive ETFs work by tracking an index. When investing in ETFs, individuals buy and sell them on exchanges, just like stocks.

Calay explains, “ETFs combine features of stocks and mutual funds, as they are listed on an exchange like stocks, but invest in a collection of stocks and bonds like mutual funds.”

“The earliest ETFs were passive investments designed to track specific indices, such as the S&P 500 or the Nasdaq. They provided investors with exposure to a wide variety of stocks within an index through a single trade.

“These passive ETFs aim to closely replicate the performance of a given index, minus their costs.”

The popularity of passive ETFs eventually led to the emergence of a new type called active ETFs.

Active ETFs, introduced by Bear Stearns in 2008, are managed by fund managers who select stocks and/or bonds in an effort to outperform the market.

Like passive ETFs, active ETFs also have benchmarks, but they aim to beat them through active investment selection, sector allocation, and other strategies.

When it comes to choosing between the two types of ETFs, Calay says, “An argument for active mutual funds is that they can close doors for new investors to stick with their strategies.

Unlike passive ETFs, which don’t have this privilege, active mutual funds can limit inflows when they reach capacity.

“This is important because asset managers who believe a fund or strategy has reached capacity can prevent new money from coming in by closing the fund to all investors.”

An example is ARK Innovation ETF, which saw a rapid rise during the height of the pandemic. This resulted in an inflow of assets in 2020 and the following year.

But unfortunately, the inability to close the doors to new investors left the ETF in a challenging situation.

With a concentrated portfolio, mostly made up of smaller companies, the resulting price increase in 2020 proved unsustainable, with average valuations doubling.

“Investors who joined the party too late have therefore suffered significant losses in 2022,” explains Calay.

How to build an ETF portfolio

When it comes to building a portfolio from a collection of funds – whether they are ETFs or not – you need to take a step back and consider the exposure you get from the underlying investments.

Campbell recommends asking, “Are you overexposed in a region?” A sector? A theme? An asset class?

“Work from first principles and think about the allocation you want in your portfolio between stocks, bonds and alternatives (such as real estate, infrastructure, private equity) and then select some funds that offer that exposure and are within your risk tolerances.”

It is also important that investors do not blindly accept that passive ETFs merely replicate an index.

“The indices that ETFs track are created by major index providers, such as FTSE Russell, MSCI and S&P Global.

These gatekeepers decide whether stocks should be included or excluded from an index and establish a broad and technical set of criteria for making these decisions.

“So while a FTSE 100 index tracker only tracks the performance of this index, the performance of that index is partly determined by decisions made by the index provider generating this index.” Campbell adds.

Some of the active ETFs available include funds such as Invesco Quantitative Strategies ESG Global Equity Multi-Factor UCITS ETF that tracks the MSCI World Index, and Fidelity Sustainable Research Enhanced Japan Equity UCITS ETF benchmarked against the MSCI Japan Index.

Add Up: Active ETFs generally have higher fees compared to passive ETFs

The cost of active ETFs

It is generally believed that actively managed investments are more expensive than passive investments due to the costs associated with active management.

Says Calay, “Active ETFs generally have higher fees compared to passive ETFs, meaning investors will pay more for active management, regardless of the fund’s performance.”

However, you can be rewarded if you pay more for active management.

Calay continues: “In our research, we found that cost is the most reliable predictor of a fund’s success. As Jack Bogle famously said, “In investing, you get what you don’t pay for.”

When it comes to buying a fund, you should always consider the total costs you incur and do your research on the cost structure.

“While you may not pay a fee to buy and sell a fund, there will be ongoing costs that will be taken out of your investment,” says Campbell.

A search of active ETFs in the UK showed costs ranging from about 40 basis points (0.40 percent) to 75 basis points (0.75 percent).

Passive ETFs that track a major index like the FTSE 100 only cost between 7 basis points (0.07 percent) and 20 basis points (0.20 percent).