Etfs: Active Or Passive Investing Approach?

Exchange-traded funds (ETFs) are available in two varieties: active and passive. Active ETFs are designed to beat the market, with fund managers actively trading securities within the fund. On the other hand, passive ETFs aim to replicate the performance of a specific market index and are a popular strategy for investors who prefer a long-term, buy-and-hold approach. While active ETFs offer more flexibility and the potential for higher returns, passive ETFs tend to have lower fees and are considered less risky. The choice between the two depends on an investor's goals, risk appetite, and investment style.

Characteristics of Passive and Active ETFs

Passive ETFs vs. Active ETFs

Exchange-traded funds (ETFs) can be either passive or active. Passive ETFs are more common and tend to be associated with passive investing strategies. Passive ETFs are popular among investors who prefer a long-term, buy-and-hold approach. They aim to replicate the performance of a specific index, sector, or asset class, and they are known for their low costs and broad diversification. On the other hand, active ETFs involve fund managers actively trading securities within the ETF to try to outperform a benchmark. Active ETFs are often more expensive due to the costs of active research and decision-making, and they may offer the potential for higher returns.

Passive ETFs tend to follow buy-and-hold strategies to track a particular benchmark. They are designed to mirror the performance of a specific index, such as the S&P 500 or Nasdaq. The fund manager of a passive ETF does not make allocation decisions beyond those that take place in the index itself. Passive ETFs provide a convenient and low-cost way to implement indexing or passive investment management, making them attractive to investors who prefer a buy-and-hold strategy. They also offer increased transparency and greater tax efficiency than active funds.

Active ETFs, on the other hand, utilise a portfolio manager's investment strategy to try to outperform a benchmark. Actively managed ETFs involve fund managers or management teams that research investment opportunities and actively select the ETF's portfolio securities and allocation according to their investment goals. Active ETFs aim to deliver above-average returns and can be beneficial to mutual fund investors and fund managers. They offer the ability to trade intraday, providing flexibility for investors who want to track short-term market movements.

While passive ETFs tend to have lower management fees, active ETFs tend to have higher management expenses. This is because the assets in active ETFs are selected and overseen by a portfolio manager who makes active investment decisions in an attempt to beat the benchmark index. The fees for active ETFs cover research, trading, security selection, and ongoing management costs.

In terms of performance, passive ETFs aim to replicate the performance of a specific benchmark index, allowing investors to participate in the overall market or a specific asset class. Passive ETFs aim to minimise tracking errors, so the basis for evaluating their performance is how closely they mirror the index they are trying to track. Active ETFs, on the other hand, have performance expectations tied to the skills and expertise of their portfolio managers. The fundamental premise of active management is to generate alpha, or returns above and beyond the benchmark index. Active managers seek to identify undervalued or overvalued assets, make strategic allocations, and time the market to capitalise on opportunities.

In summary, passive ETFs offer a low-cost, diversified investment option for those seeking a long-term, buy-and-hold strategy. Active ETFs, while potentially more expensive, offer the potential for higher returns and are suitable for investors seeking to outperform the market.

The pros and cons of passive funds

Passive investing is a strategy that focuses on long-term investment and staying invested through the ups and downs of the market and the economy. It is often referred to as a buy-and-hold approach, as it aims to minimize buying and selling investments in response to market conditions. The goal is to mirror the market's returns, rather than trying to beat them. Passive investors believe that investing broadly, diversifying, controlling risk, and keeping fees and taxes low will lead to the best returns.

Pros of Passive Funds:

• Lower fees: Passive funds tend to have lower management fees compared to active funds, as there is no active manager trying to beat a benchmark.
• Greater tax efficiency: Passive funds that use a buy-and-hold strategy typically generate low or no taxable capital gains for shareholders.
• Simplicity: Passive funds are easier to understand and implement than active funds, as they follow a set index.
• Lower risk: Passive funds are diversified across many companies, reducing the risk of any one company failing.
• Lower costs: Passive funds do not rely on market forecasts, company research, or active trading, resulting in lower costs for investors.

Cons of Passive Funds:

• Lack of flexibility: Passive funds are limited to a specific index or set of investments and cannot adapt to market conditions.
• Smaller potential returns: Passive funds rarely outperform their benchmark index and usually return slightly less due to operating costs.
• Total market risk: When the overall market declines, passive funds tracking the index will also decline.
• Lack of control: Investors cannot hand-select or drop any particular company in the index.

Overall, passive investing can be a great option for hands-off investors who want returns with less risk over a longer period. By keeping costs and taxes low and focusing on diversification, passive funds aim to mirror market returns and provide solid long-term gains.

The pros and cons of active funds

Exchange-traded funds (ETFs) can be either actively or passively managed. Passively managed ETFs are often seen as a "buy-and-hold" investment, while actively managed ETFs involve fund managers who actively trade securities to try to outperform the market.

The Pros of Active Funds

• Opportunity to outperform the market: Active funds can outperform the market on the upside and limit losses when the market declines.
• Flexibility: Active investors can make changes to their portfolios in response to market fluctuations or economic events, allowing them to potentially outperform during volatile markets.
• Tax-loss harvesting: Active investors can sell underperforming investments to offset capital gains taxes on high-returning investments.
• More choices: There are more actively managed funds available, providing investors with greater access to different investments.

The Cons of Active Funds

• Potential to underperform the market: There is no guarantee that active funds will outperform the market, and many fail to beat their benchmarks when expenses are factored in.
• Higher fees: Actively managed funds tend to have higher fees due to the costs of research analysts, portfolio managers, and frequent trading.
• Lower tax efficiency: The frequent trading in active funds can lead to higher capital gains taxes.
• Trading eats up gains: The frequent trading in active funds can result in higher transaction costs, reducing overall gains.

Passive investing vs. active investing

Passive investing and active investing are two opposing approaches to investing that have been debated in the financial industry for a while now. Both strategies have their own advantages and disadvantages, and the best approach for an investor depends on their personal priorities, timelines, and goals.

Passive investing is a long-term, buy-and-hold strategy where investors aim to track and achieve the return of a specific market index rather than trying to beat the market. Passive investors rarely buy individual investments, instead of holding an investment over a long period or purchasing shares of a mutual or exchange-traded fund. Passive investing is more prevalent among retail investors as it offers low fees, transparency, and tax efficiency. Passive ETFs tend to be lower-cost and more transparent than active ETFs, but they do not provide any opportunity for outperformance.

On the other hand, active investing takes a hands-on approach, requiring investors to regularly buy and sell stocks or other investments based on their short-term performance. Active investors aim to beat the market's average returns and take advantage of short-term price fluctuations. This strategy involves deeper analysis and expertise in knowing when to pivot into or out of a particular stock, bond, or asset. Active investing is generally more expensive due to the need for research analysts and portfolio managers, as well as higher transaction costs.

Historically, passive investments have earned more money than active investments, and passive funds have tended to outperform active funds due to their lower fees. However, active investing has become more popular, especially during market upheavals. Additionally, active investing may be more suitable in certain investing climates, such as when the market is volatile or the economy is weakening.

In conclusion, both passive and active investing strategies have their merits, and many investment advisors believe that blending the two approaches can help minimize the wild swings in stock prices during volatile periods and further diversify a portfolio.

The difference between passive and active funds

Exchange-traded funds (ETFs) can be either passive or active. Passive investing is a long-term, buy-and-hold strategy that aims to replicate the performance of a specific market index. Active investing, on the other hand, involves fund managers actively trading securities within an ETF to try and outperform the market. Active investing takes a hands-on approach, requiring regular buying and selling of investments based on their short-term performance.

Passive investing is a popular strategy for investors who prefer a long-term approach and offers a convenient, low-cost way to implement passive investment management. Passive ETFs tend to follow buy-and-hold strategies and aim to track a particular benchmark, such as the S&P 500 or the Nasdaq. The fund manager of a passive ETF does not make allocation decisions beyond those that take place in the index itself, providing a low-cost, transparent, and tax-efficient way to invest. Passive ETFs also offer investors greater flexibility to execute a buy-and-hold strategy compared to active funds.

Active investing, meanwhile, involves fund managers actively selecting investments and making allocation decisions to try and outperform the market. Active fund managers use their expertise and research to identify investments they believe will perform well and make buying and selling decisions accordingly. Active investing requires a more hands-on approach and is, therefore, more expensive due to the higher management fees involved.

While passive investing has become an increasingly popular strategy, active investing has its place in the market, particularly for investors seeking to generate returns above and beyond the broader market performance. Active investing can be useful for investors looking to adapt to adverse market conditions and benefit from short-term price fluctuations.

Both passive and active investing strategies have their advantages and disadvantages, and many investors choose to blend the two approaches to benefit from the strengths of each.

Frequently asked questions