Are Actively Managed ETFs Better Than Passively Managed ETFs?

| August 6, 2012 | 0 Comments

The exchange traded fund (ETF) isn’t a new concept for most investors.  These convenient investment vehicles have been around for nearly 20 years now in the US.

For those who don’t know, an ETF is a securities portfolio that trades like a stock on an exchange.  Similar to mutual funds, ETFs hold assets like stocks, commodities, or bonds.  But unlike a mutual fund, an ETF can be bought and sold anytime throughout the course of the trading day.

Most ETFs track an index and are passively managed. 

In other words, the ETF holds all of the securities in the index or a representative sample of them.  The only time a security moves in and out of the ETF is when changes are made to the index it’s tracking.

A perfect example is the Spider…

That’s the nickname given to the ETF which tracks the S&P 500 Index – the SPDR S&P 500 (SPY).  With over $100 billion in net assets, SPY is the fourth largest ETF on the market today.

There’s no question many investors prefer passively managed index ETFs.

They can be counted on to closely track the performance of the underlying index.  What’s more, investors always know the risk profile of these ETFs up front and what securities are held in the portfolio.

But passively managed ETFs are starting to get competition from a new kind of ETF… the actively managed ETF.

These ETFs have a manager or team making decisions about the portfolio’s asset allocation.  While they typically have a benchmark index, the managers may change sector allocations, market-time trades, or deviate from the index as they see fit.

The objective is that the managers will provide returns over time that beat the returns of the underlying index.

Of course, the opposite is also true… the managers can underperform the baseline index if they make poor investment decisions.

As I said earlier, actively managed ETFs are a relatively recent phenomenon.   There are only about 50 of them on the market currently.  And they garner just a small fraction of the $1.2 trillion invested in ETFs overall.

However, actively managed ETFs are quickly growing in popularity with investors.

Since the first one was introduced in 2008, investors have poured more than $7 billion into these funds.  Many people are clearly looking for an investment vehicle that has potential to outperform the market.

So, are actively managed ETFs really better than passively managed ETFs?

There’s no black and white answer to this question.  However, actively managed ETFs have a couple of inherent drawbacks that could limit their potential to beat the market.

First off, an actively managed ETF typically carries a higher expense ratio than a passive ETF.  This is due to actively managed funds requiring more attention from the fund’s managers.

According to Morningstar, the average expense ratio for passively managed stock ETFs is just 0.49%… compared to 0.82% for actively managed ETFs.

While a higher fee makes sense, it is a risk factor.  You see, a higher fee makes it tougher for the actively managed ETF to beat its benchmark.

Second, you may not be getting the best stock-picking managers with actively managed stock ETFs.  The best managers are reluctant to manage these funds because ETFs tend to disclose their holdings on a daily basis.

This practice exposes actively managed ETFs to front-running of their stock picks by hedge funds and high-frequency traders. 

Front-running is where a trader identifies the stocks in which an ETF manager is building a position and starts buying the shares.  This often drives up the price of the shares while the manager is still buying them.

As long as ETFs have to disclose their holdings so frequently, it’s a good bet the best fund managers will stay away from managing them.

So, if you’re considering an actively managed ETF for your own portfolio, be sure to understand the risks.  Just because a portfolio is actively managed doesn’t mean it will necessarily outperform its benchmark index.

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Profitably Yours,

Robert Morris

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Category: ETFs

About the Author ()

Robert Morris is the editor of Penny Stock All-Stars, an investment advisory focused on discovering small-cap and micro-cap stocks that are destined to become the market’s next Blue Chips. The Wall Street veteran and small-cap stock specialist is also a regular contributor to Penny Stock Research. Every week, Robert shares his thoughts with our readers on a variety of penny stock-related topics. In addition to Penny Stock Research, Robert also writes frequently for two other free financial e-letters, ETF Trading Research and the Dynamic Wealth Report. He’s also the editor of two highly successful and popular investment advisories, Biotech SuperTrader and China Stock Insider.

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