Active or Passive – How do you decide? Part I

Working for an ETF fund manager, investors and financial advisers simply presume that I’ll always favour a simple passive index-tracking ETF.  Make no mistake, whilst I may think that indexing is the way to go most of the time because of the obvious benefits of instant diversification, lower costs, and the historical inability of the majority of active managers to outperform their benchmarks, some of my clients are surprised when they hear me speak about active strategies.

The truth is that I firmly believe that active strategies have their role in portfolios alongside index and Smart Beta/rules-based ETFs.

However, as an investor how do you decide which approach to use?

In part one of this two-part series, I will take you through the definitions of each so you have a clear understanding of what I am referring to.

First and foremost (and yes I am biased here!) no matter which strategy you decide to go with, in my opinion the best way to access these strategies is through an ETF or exchange traded product.  Using an ETF rather than an unlisted fund or listed investment company (LIC) gives you 3 main advantages:

Liquidity

ETF liquidity is measured by the liquidity of the stocks included in the underlying index, not what is shown on screen (which is a typical measure of liquidity in the case of stocks or LICs). Additionally, you can buy and sell during the trading day instead of having to wait till the end of day as you would for unlisted funds. See here for more information on ETF liquidity.

Generally trades close to NTA

Due to the open-ended nature of ETFs, the price on offer is generally very close to the Net Asset Value (NAV) of the fund. This differs from LICs, which are closed-ended, and therefore the price is based on the price at which other investors are willing to buy and sell the shares at that time.  With this closed-ended structure, shares may trade at a significant premium or discount to NAV.

Tax efficiency

ETFs generally create fewer taxable events than most unlisted managed funds because of lower turnover, which means there should be fewer capital gains to distribute. Additionally, when an investor in a managed fund sell units, the fund manager must typically sell down securities to raise cash to meet the redemption.  For ETF investors, because units are traded on-market, the units may be sold to another investor or back to a market-maker who can then sell again. So on-market selling doesn’t always lead to activity in the underlying securities portfolio.

Exchange traded products have gone through an evolution over the years like products in other industries:

At first there were passive index-tracking ETFs which seek to mirror the performance of a specific investment index, bond index, sector index and which often utilise a simple market cap weighted methodology or simply track a specific commodity or currency, or group of commodities and currencies.

After plain index ETFs, products utilising Smart Beta methodologies and rules-based products hit the scene.

Smart Beta/rules-based exchange traded products typically use a systematic, rules-based investment approach. Some of these approaches can still be index tracking – however such indices typically go beyond market-cap weighted methodologies and may consider things like size, value and volatility as an alternative weighting methodology. Other products in this category may not actually seek to track an index at all, but may 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 sharemarkets).

The most recent development, and one that is starting to get more popular in Australia are Active ETFs.

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 managers’ main goal is to try to outperform a benchmark index by actively trading or changing sector allocations as they see fit.

That concludes part one!

Make sure you check out next week’s post, as I go through a few features to consider when deciding if plain indexing, Smart Beta/rules-based, or going actively managed is the way to go for your investment objectives.