For years, exchange-traded funds, or ETFs, have been a smart way to invest — for the same reason people buy index funds. Traditional ETFs (known as passive ETFs) typically buy a basket of stocks or bonds to track or mirror a market index, while keeping fees low. Lately, though, growing numbers of investors have been putting money into actively managed ETFs or active ETFs. Zacks Investment Research said in a Seeking Alpha post that the number of unleveraged active ETFs has more than doubled between 2013 and 2017.
The Risk of Active ETFs
Problem is, active ETFs may be riskier than you think.
Unlike passive ETFs, actively managed ETFs take a hands-on investing approach. Instead of simply owning and then tracking an index, they typically hire a manager or team of portfolio managers who alter the investments comprising the underlying portfolio, hoping to do better than the index.
In some cases, the actively managed ETFs simply tweak the holdings of the index they follow to deliver specific strategies. This makes them not so much “active” ETFs as “adjusted” ETFs. For example, Vanguard’s smart beta ETFs add criteria to the basic indexes make them value or momentum ETFs.
And some actively managed ETFs seek to create so-called “enhanced” or “intelligent” benchmarks, using quant-based strategies when constructing a portfolio, aiming to outperform traditional indexes that are weighted by capitalization.
What this all means is that actively managed ETFs produce returns that don’t mirror the index — for better or for worse. Their ETFs appeal to investors who aren’t willing to settle for the “average performance” that passive ETFs and index funds offer.
It’s important to remember this, however: Research has shown that actively managed funds tend to underperform their passively managed counterparts over time, especially when fees are taken into account.
If You Are Considering Active ETFs
Nevertheless, if you’re considering investing in an active ETF, look for a manager with an edge of some kind.
This means, your best bets among passive ETFs are alternative investments that usually have a low correlation to the overall stock market. In essence, you’d be looking for ways to hedge against the stock market rather than mimic it. Examples might include actively managed ETFs specializing in small capitalization stocks, international stocks or high-yield bonds.
If you want to mimic the market, however, it might be a good idea to consider passive ETFs rather than buying active ETFs. You may want to work with a good investment adviser to help come up with smart active-investing strategies, identifying opportunities to get the best of both worlds.
The number one thing to avoid when considering an actively managed ETF is one run by poor management. Every actively managed ETF is only as good as the person or people calling the shots.
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