As an investor for over 25 years, I have owned my fair share of active ETFs2 and purely passive/index ETFs.3 I have been happy with a good number of the ETFs in both the active and index categories. However, there have been many disappointments as well.
Pure passive ETFs can offer investors the convenience of having their allocations track the behavior of broader market, often at fees that are lower than actively managed ETFs. In my own experience with pure passive ETFs, I look back at my choices as being somewhat mindless. I turned my hard-earned dollars over to a market capitalization weighted4 or debt weighted5 index approach, which in some cases was created years if not decades before. The creator may or may not remain involved in the index construction, and may or may not even still believe it to be the best way to access a given market. Certainly, by deciding to buy the given pure passive ETF, I had made an active asset allocation choice, but it stopped there.
The other disappointment that I’ve faced with pure passive ETFs is most acutely felt in down markets. There have been many times when I’ve had the belief that a given sector, industry, region, or country may be headed for trouble in the future, but by owning a passive ETF, there was no way for the index portfolio manager or me (short of selling the ETF and taking a possible gain) to react in an attempt to protect assets in a down market. Furthermore, many of the indices are only changed twice a year or so, and judgement based on market events is rarely brought to bear on investment decisions.
The last element that bothers me about pure passive ETFs is that I’m not in a position that is designed to outperform. I likely have no choice but to settle for below actual index returns, since the passive strategies are designed to track an index, not outperform them, and ETFs’ expense ratios will reduce returns. By contrast, active ETFs have the potential to outperform the index it seeks to track.
For these reasons, I’ve come to favor active management in ETF strategies wherever they are available. I really like the idea of picking a manager who is personally responsible for the wellbeing of my money. These portfolio managers typically have a lot of their own money invested in the active ETF as well, so you know they care. I also like the fact that there is a pilot guiding the plane if the air gets choppy – giving me at least the opportunity to have some of my hard earned dollars shielded from a market decline.
I realize I have to pay more for the benefit of potentially performing better than average, and for the benefit of potentially reducing risk in a down market, but I’m prepared to do so, assuming the fee is competitive with like ETFs and mutual funds.
Know Your Goals and Your Plan
Well, there you have it, a few brief musings as I think back at my 25 years of investing. When it comes to investing and financial planning, the best guidance may be to clarify what your personal goals are and consult with a professional about how best to meet them. Both pure passive and active ETF strategies offer potential advantages and disadvantages, depending on risk tolerance, goals, and personal circumstance.
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1 An exchange-traded fund, or ETF, is a marketable security that tracks an index, commodity, bonds, or a basket of assets like an index fund. ETFs trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value.
2 Active ETF structures do not track an index. The term active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. Passive management (also called passive investing) is an investing strategy that tracks a market weighted index or portfolio.
3 The term passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. Passive ETF structures track an index.
4 A capitalization-weighted (or “cap-weighted”) index is a stock market index whose components are weighted according to the total market value of their outstanding share.
5 The term debt weighted refers to the practice of capitalization-based weighting that utilizes the outstanding market value of bonds. Companies with more debit have a higher allocation in a corporate bond index.