Exchange traded funds (ETFs) are a hugely popular investment vehicle for good reason – they are cheap, easily accessible, highly diversified and you can start investing with only a few hundred dollars! For these reasons, we incorporate ETFs in all our client portfolios.
As the popularity of ETFs has increased over the years, so have the types of ETFs available. Back in 1993 when ETFs were first created, they were very vanilla. They simply tracked an index (which, by the way, is a great way to invest!). Now days, there is so much more on offer.
What is an ETF?
An ETF is a pool of investments, held in a trust structure, which you can buy through a stock exchange. To put it simply, think of an ETF as a bucket. The bucket holds lots of different assets, often shares, but the assets can also be bonds, currency, commodities, etc.
You buy an ETF like you would buy any other company listed on a stock exchange, i.e. with an online broker account. When you buy the ETF you add to the bucket and will get exposure to all the underlying assets of the bucket. The amount of exposure depends on the ETFs investment mandate.
Now that we know what an ETF is, let’s look at the different management styles of ETFs available. The management style refers to how the assets in the bucket are selected and broadly speaking there are three different ETF types; passive, active and smart beta.
Passive ETFs
A passive ETF simply tracks an index (boring but it gets the job done!). For example, you can invest in an ETF which tracks the ASX 300. By doing so, you will get exposure to the top 300 stocks listed on the ASX.
The amount of exposure to each stock is going to depend on the market capitalisation (or size) of each stock. As a result, you get the most exposure to the biggest company listed on the ASX, the second most exposure to the second biggest company listed on the ASX, and so on.
Passive ETFs are the traditional style of ETF and they are a great option for the following reasons:
- Very cheap. All the trading is done by computers with no human intelligence involved in stock selection which keeps the cost down low…real low. The management costs of a passive ETF generally lie between 0.03% and 0.40% per annum.
- Well diversified. You are getting exposure to an entire index through a single holding. This is a great way to get diversification in your investments and diversification is key to being a prudent investor!
- Passive investing often outperforms over the long run. The SPIVA Scorecard suggests that 77% of Australian active fund managers underperform their benchmark over a 10 year period. Even Warren Buffett, one of the greatest active managers of all time, recognised this when he famously made a $1 million bet with Protégé Partners back in 2008 that they wouldn’t outperform the S&P 500 index over a 10 year period. He won that million dollar bet and collected in 2018.
As you can see, there are a lot of benefits to passive ETFs but, like every investment, there are also downsides which you need to take into consideration. Some of the downsides of passive ETFs are as follows:
- You will only ever get a beta return. A beta return is a return that is 100% correlated with the market. The market goes up 10%, you make 10%. The market goes down 10%, you lose 10%. Many investors like to ‘beat the beta’ and outperform the relevant index.
- Overweight exposure to particular stocks. As the level of exposure is determined by the market capitalisation of the underlying stocks, there is a good chance that you will be overweight in some holdings. For example, the ASX 300 is dominated by the top 10 holdings which make up over 40% of the index.
- Inability to target specific portfolio outcomes. Portfolios should be developed with an investment objective in mind. For example, if you require income, you may choose to focus on a dividend producing portfolio with franking credits. It’s harder to target specific portfolio outcomes with passive ETFs alone.
There are a few things to consider there but overall, passive ETFs are a great option for many investors. Their ability to give you high diversification, at a very low cost, with a good historical returns, mean that they earn their spot as the backbone of many portfolios.
Active ETFs
As the name suggests, an active ETF is actively managed. It still the same ‘bucket’ structure, but instead of those assets being determine by an index, they are hand selected by portfolio manager or team.
For example, you might have an active ETF with a mandate to produce a income from Australian shares. Under this mandate, the portfolio manager would be actively picking high dividend paying stocks to put into the bucket.
The benefits of actively managed ETFs include:
- Exposure to fund managers expertise. Remember we said that the SPIVA Scorecard suggests 77% of fund managers won’t outperform the index over a 10 year period? Well if you select the 23% that does, you are going to get a better return than a passive investor.
- Ability to target portfolio objectives. This allows you to tailor portfolio outcomes to suit your situation.
- Active managers can hold cash. In a market downturn, it may be beneficial to have some cash in the portfolio. This would reduce downside risk while also leave capital available to buy more assets when they are cheap. Active managers can make these calls and, provided they get the call right, this can generate outperformance.
Again, plenty of benefits to active management but they do come with a number of potential downsides as follows:
- Increased cost. Investment decisions are made by people, not computers, who charge for their time and expertise. The management fee of an active ETF is often more than double that of a passive ETF. Given this, the manager needs to outperform by at least their fee, to get the same return for investors.
- Active managers often don’t outperform the index. We have looked at the numbers, 77% will likely not outperform the index over 10 years. Given this, you can’t expect an alpha return on your money just because you are paying a premium for active management.
- Active ETF managers often don’t disclose their full portfolio holdings. What this means is that you don’t actually know what is in the bucket you are buying into. Often, it is only the top 10 holdings that are disclosed to investors. This isn’t the manager being deceptive, it’s them protecting their intellectual property – they don’t want other people copying their ideas! Given this, if you are someone that needs to know everything about an investment, then maybe an active ETF isn’t for you.
Again, I really like active ETFs. I incorporate them into my portfolios regularly, not only to try for alpha performance in client portfolios, but also to target specific investment objectives.
Smart Beta ETFs
The last type of ETF I want to look at are smart beta ETFs. These ETFs use a rules based approach to manage what assets go into the ‘bucket’. I guess you could say they are a hybrid between passive and active, but essentially they have an automatic screening process which determines what assets to invest in.
An example of a smart beta ETF is an equal weight ETF. Remember when I said that you can buy a passive ETF in the ASX 300 but it primarily made up of the top 10 companies? Well that’s where you could use an equal weight ETF to overcome this issue.
An equal weight ETF doesn’t care about the market capitalisation (size) of the companies in the index. They use a rules based approach to give you equal exposure to the top companies. If you compare this to a passive ETF, you will be getting a lot more exposure to those mid cap stocks and proportionally less to the blue chip stocks.
The benefits of a smart beta ETF include:
- Potential outperformance. As you do with active management, rules based management gives you the potential to outperform the relevant index. Again, this is not guaranteed, but it does give you that portfolio alpha that a lot of investors search for.
- Cheaper than active management. As the manager simply sets the rules and lets the computer do the rest, it is less hands on. This allows fund managers to provide the product at a cheaper cost. Smart beta ETFs usually charge a management fee somewhere in between passive and active management.
- Ability to target portfolio objectives. Like with an active ETF, you can choose a smart beta ETF which has a rules based approach which is in-line with your preferred investment method. This allows you to target particular portfolio outcomes provided you find the right rules based approach.
Smart beta ETFs have some factors to consider before investing. This includes:
- Not as cost effective as passive. Although there is not a whole lot of human intelligence involved in this form of ETF, there is still a little. As a result the cost is often slightly higher than that of a passive ETF.
- No guarantee that you will outperform the index. Just because there is a rules based approach behind the scenes doesn’t mean that it is going to outperform. Again, statistics suggest that it is very hard to outperform the index and this applies to rules based investing as well.
Personally, I am a big fan of all styles of ETFs! They are a great investment vehicle which give you diversification and liquidity at a low cost. In my opinion, ETFs should form the backbone of your portfolio with a little extra something sprinkled around them to get the alpha (potentially!).
If you are thinking about investing in ETFs try to stick with the key players in the market which have been around for a while. There are synthetic ETF providers out there which don’t actually own the underlying securities of the portfolio or, in other words, they don’t actually own the assets in the bucket. Instead they use derivatives and swaps to replicate it which comes with extra risks.
I hope you found this helpful. If you would like to learn more about how we construct our portfolios, check out our Portfolio Methodology. If you need professional guidance to put together a suitable portfolio for you, check out our Tailored Advice offering.
Happy ETF investing!
