As the Canadian ETF industry continues to expand, so too does the array of strategies available to investors, which can make picking the right one slightly difficult and confusing at times.
An easy way to begin your ETF investing journey is by searching according to pre-set categories, based on things like sector, asset class, geographic focus, or thematic basis. However, a more fundamental categorization emerges when considering an ETF's investment strategy - active or passive management. You can filter on any of these attributes using the Cboe ETF Screener.
Whether you're a seasoned investor seeking to diversify your portfolio, or a beginner intrigued by the realm of ETFs, understanding the difference between active and passive ETFs can significantly influence your investment decision and overall portfolio strategy.
In this comprehensive guide, my goal is to equip you with a clear understanding of both active and passive ETFs, covering their unique operational mechanics, providing real-world examples, and discussing their respective advantages and drawbacks.
Staying passive
Passive ETFs, as their name suggests, follow a hands-off investment strategy. Instead of actively trying to beat the market and pick winning stocks, these funds simply aim to mimic or track a specific market index, such as the S&P/TSX 60 in Canada, or the S&P 500 in the United States.
An index is basically a snapshot of a specific segment of the financial market, containing a basket of different securities like stocks or bonds. It selects and manages its constituents based on a pre-set, strict, and objective methodology. However, you can't invest directly in an index.
Therefore, the work-around is with passive ETFs. These ETFs will buy and hold stocks or bonds to replicate the holdings of a benchmark index. Thus, by buying the passive ETF, you're gaining exposure to the risks and returns of the index.
The main advantages of passive ETFs are their low costs and broad diversification. Because these funds simply mirror an index, they require less management and therefore have lower expense ratios than active funds and can sometimes have better tax-efficiency due to lower fund turnover.
Moreover, since they encompass a wide array of companies within a given index, they can offer investors a way to spread their risk across many different securities. Overall, passive ETFs can be a great choice for Canadian investors who want a low-cost, straightforward way to match the market's return.
Examples of popular Canadian passive ETFs include the BMO (TSX:BMO) S&P 500 Index ETF (ZSP) and the iShares S&P/TSX 60 Index ETF (XIU).
Going active
In contrast to passive ETFs, active ETFs employ a more hands-on or 'active' approach to investing. Instead of simply tracking an index, these funds are managed by professionals who actively make decisions about how to allocate the fund's assets.
The goal of an active ETF is usually to outperform a specific benchmark index rather than just mirroring it. They may also have secondary goals, such as ensuring a higher level of income, or hedging against downside risk. Regardless, none of these ETFs will track an index.
Instead, active ETFs use a variety of strategies to try to achieve superior returns. They might focus on in-depth research, market forecasts, quantitative screeners, and complex financial models to identify and invest in securities they believe will perform better than others.
In addition, active ETFs may buy and sell securities more often. This could involve focusing on a particular sector, choosing investments based on company fundamentals, or timing the market to buy and sell at optimal points to lock in a profit or reduce losses.
For instance, if you invest in an active ETF focused on the Canadian technology sector, the fund manager would be making decisions about which tech companies' stocks to buy or sell based on their analysis and predictions about future performance.
Examples of popular Canadian active ETFs include the BMO Low Volatility Canadian Equity ETF (ZLB) and the NBI Unconstrained Fixed Income ETF (NUBF).
Active versus passive
So, which is better? I'll let you decide after going over the main arguments for and against both.
When it comes to passive ETFs, the biggest benefit are low fees, coupled with a level of diversification that is difficult to achieve individually, as they mimic a specific index giving investors exposure to a variety of market sectors or asset classes.
Passive ETFs also offer a high degree of transparency, allowing investors to understand how the ETF works. Lastly, they provide consistency with performance that closely mirrors the index they track. While this means they won't typically outperform the market, they also shouldn't significantly underperform it.
However, passive ETFs do come with some drawbacks. The primary downside is the limited potential for gains. Since they aim to match the market rather than beat it, they don't usually generate higher-than-average returns. With passive ETFs, you have to accept never being able to beat the market.
Additionally, investors in passive ETFs have little to no control over the individual securities the fund invests in, as these are dictated by the index the ETF tracks. If there's a stock you don't like, there's nothing you can do. Finally, if the index falls, your passive ETF is going to tumble along with it.
On the flip side, active ETFs have the potential for greater returns. The active approach allows fund managers to react to market conditions, adjust holdings, and attempt to capitalize on investment opportunities as they arise.
This ability to adapt can be particularly beneficial during periods of market volatility, where active ETFs can implement defensive measures by hedging, holding cash-like investments, or shorting the market to turn a profit or reduce losses while passive ETFs must bear the brunt of losses.
However, the success of active ETFs largely depends on the skills and judgement of the fund manager, adding an element of human risk. Despite the best efforts and analysis of experienced managers, active ETFs can still underperform the market, especially after factoring in higher fees.
For instance, the long-standing SPIVA (S&P Indices Versus Activel) Scorecard found that over the last 15 years, 93.40% of all actively managed U.S. large-cap funds underperformed the S&P 500 index, showing how hard it is for active management to outperform as time goes on.
The final word on active and passive ETFs
Indeed, the choice between active and passive ETFs isn't an either-or proposition. In fact, incorporating a mix of both into your investment portfolio can create a balance of risk and return that suits your specific financial goals. This could take the form of a 'core and satellite' approach.
Your core portfolio, the mainstay of your investments, might consist of passively managed ETFs. This would provide a cost-effective, diversified foundation that tracks the broader market. Simultaneously, your satellite holdings could involve a smaller portion of actively managed ETFs, potentially allowing for higher yields, risk mitigation, or market outperformance.
It's important to remember that the investment landscape is dynamic and ever evolving. In recent years, we've witnessed the emergence of a new breed of ETFs known as 'smart beta' or 'factor' ETFs. These funds represent a hybrid between active and passive strategies.
Smart beta ETFs track indices just like traditional passive ETFs, but the indices they track are constructed using rules that consider special factors, such as volatility, size, momentum, quality, or value. This approach aims to combine the best of both worlds: the broad diversification and low costs of passive investing, with the potential for outperformance typically associated with active management.
As the lines between active and passive ETFs continue to blur, it’s more important than ever for investors to understand the underlying strategies of their investments. Making informed decisions based on your individual risk tolerance, investment horizon, and financial objectives can help you navigate the complexities of the ETF landscape.
For an easy way of screening active and passive ETFs, Canadian investors can use the Cboe ETF Screener, which currently provides up-to-date data and metrics on 687 active ETFs and 674 passive ETFs.
This content was originally published by our partners at the Canadian ETF Marketplace.