Exchange Traded Funds (ETFs) are often considered by modern investors to be very efficient investment vehicles. Therefore, it is no surprise that the ETF investing space has attracted so much attention recently. While you probably have heard of an ETF before, you may not be familiar with all of the attributes that make ETFs different from other investments.
Although investing in ETFs is easy, understanding all of the most noteworthy concepts can be time consuming and complicated. Rather than leaving you to search for hours online we have written a short guide to define ETFs and cover the specifically relevant introduction topics.
So, we have gained an understanding of the fundamental terminology used for ETFs. Now we need to know how these various components work and how they function in the larger context of the world financial markets. This material reviews the basics while periodically adding layers of complexity and introducing new concepts. By the end of this, you will have the necessary knowledge to think critically about ETFs. You will be able to start the to start the journey towards a safer financial future by using ETFs.
What is an ETF?
An investment that consists of large number of stocks or other financial instruments.
ETFs or Exchange Traded Funds are investment vehicles similar to mutual funds with shares that any investor with a brokerage account can buy or sell. ETFs are exchange traded, meaning they have a ticker symbol on an exchange and can be easily bought or sold like an individual stock. This flexibility allows investors to easily gain exposure to a basket of stocks, bonds or commodities by investing only in the ETF, rather than managing a big portfolio which is both complex and expensive.
Who Manages the ETF?
The funds do need some management. The assets of the ETF are managed by a team of portfolio managers. Depending on the strategy of the fund this may simply mean replicating an index like the S&P 500, investing all the assets of the fund in a commodity like gold, or executing a strategy that involves fundamental or quantitative analysis.
How much does it cost?
All this fund management does come at a cost. Similar to a mutual fund, an ETF manager charges a management fee that can range from almost zero to several percentage points. Management fees are one of the biggest aspects for investors to consider when investing in ETFs. Fees can sometimes be the difference between having profitable returns or losses.
ETF vs. Mutual Fund
ETFs have real-time pricing, lower expenses, no minimum investments, and can be more tax efficient.
Some mutual funds and ETFs share similar strategies but their structures are very different, often giving ETFs an advantage.
Mutual funds and ETFs are two of the most popular investment vehicles for individual investors. Mutual funds have been a go-to investments for a long time but ETFs have recently emerged, providing similar services under more efficient terms. Agonizing on determining whether to invest in the ETF or Mutual Funds might seem pointless, but there are differences that one should consider before making an investment decision.
Pricing and trading is the first major difference between two investments. Mutual funds price at the end of the day when the price of the fund is set which is also when mutual fund securities are bought and sold. On the other hand ETFs are priced throughout the day and can be bought and sold throughout the day as they trade, similar to stocks.
Mutual Funds often have a more hands-on management team. This means that they have teams that trade individual stocks or bonds prescribed by the strategy outlined in the fund’s prospectus in a more active fashion. On the contrary, ETFs often but not always track an index and are therefore at times less active. With less activity comes lower expenses and thus lower fund management fees that an investor pays to own an ETF versus a Mutual Fund. In addition, mutual funds include expenses such as commissions, redemption fees and operational expenses as well as applying investment minimums ranging from $500 to $3,000. ETFs on the other hand only charge the operating expenses which are generally low and have an investment minimum of a single share.
With every investment there comes important tax considerations as they impact the bottom line returns of the ETF and Mutual Fund investment. When an investor sells the ETF security, it is sold to another investor therefore it only switches from one investor to another. This does not force the ETF to liquidate its holdings to pay back the investor that sold the ETF since the sold security only changed hands (from one investor to another). As the ETF does not have to sell its holdings it is not impacted by capital gains at the fund-level which insulates the remaining investors in the fund. In an event where the Fund redeems shares and sells underlying holdings, it can elect to sell the most tax efficient securities, minimizing capital gains. Mutual Funds on the contrary have higher capital gains due to their often more active management. In addition, once an investor sells the mutual fund, the fund has to liquidate holdings to pay back the investor that sold its mutual fund. This becomes a capital gain event for all investors in the fund, lowering tax efficiency for all investors.
Few features make ETFs tax efficient investment vehicles
If you are looking for a tax-efficient investment, ETFs have some unique advantages but there are a few things to keep in mind when making a selection. The primary tax consideration for many investors is capital gains and it is often what makes ETFs particularly attractive. In addition to capital gains, some other important aspects that impact taxation are the length of time the investment has been held (long-term or short-term capital gains), the legal status of the investment vehicle (open-end fund, unit investment trust, grantor trust, limited partnership, or exchange-traded note) and the underlying assets (equities, fixed-income, commodities, currencies, or alternatives).
One unique tax advantages ETFs have over mutual funds pertains to capital gains distributions. ETFs typically distribute much less in capital gains than mutual funds. Since many ETFs track indexes while mutual funds tend to be more actively managed, ETFs have less trading activity and therefore fewer capital gains.
The sales activity of investors in a fund is something else that distinguishes ETFs from mutual funds. While both an ETF and a mutual fund hold investment assets, when an investor in a mutual fund decides to exit the fund, the portfolio manager needs to sell positions in the fund to generate cash for the investor, which generates capital gains for all investors in the fund. This differs from an ETF where the investor simply sells his/her shares to another buyer exiting the investment without creating a taxable event for other investors in the fund.
ETF Share Redemption
Creation and Redemption, the process ETF managers perform to create and redeem shares also creates tax efficiency. As an ETF manager transacts with broker-dealers to redeem shares, the manager can select which assets in the portfolio to exchange. This allows the ETF manager to select assets with the highest capital gains, effectively washing the fund of potential capital gains.
Expense ratio is expressed in percentage and indicates how much an investor pays to own an ETF
Fees or expense ratios are an important consideration when choosing an ETF investment as they can eat into returns and can lead to large opportunity costs in the long run.
Expense Ratio is expressed in percentage and represents the cost of owning an ETF on an annual basis. For example, Expense Ratio of SPY ETF is 0.04%. This means that an investor pays 0.04% on their investment annually, which translates to $4/yr on a $10,000 investment.
But not all ETFs are cheap. Depending on their strategy, liquidity, and business model, some ETFs are more expensive than others, even when tracking the same index. Investors should always consider the fund’s costs before investing.
That said, ETFs remain a very efficient way for investors to gain access to broad market indices, sectors or investment strategies if they do their homework.
Creation / Redemption
The process of how shares of existing ETFs are created or removed from the market.
One unique element of ETFs is the creation and redemption process. Although ETFs trade on stock exchanges they do not get there through an initial public offering (IPO). Instead, ETFs use a process called creation and redemption that allows for the continuous creation and destruction of shares. When an investor buys shares in an ETF the big question is, “where do the shares come from initially?”.
A group of broker-dealers called authorized participants (APs) who act as market makers for the ETF are authorized by the fund to create and redeem shares. The AP creates new shares of an ETF by transacting with the ETF manager. ETF managers publish on a daily basis the intended composition of the portfolio. The holdings of each ETF are disclosed publicly each day and are referred to as the “creation basket”. These holdings are also used to calculate the net asset value (NAV) of the portfolio. AP buys up the stocks in the creation basket which is delivered to the ETF manager in exchange for shares of the ETF. The AP then sells the ETF shares to individual investors. The process works the same way in reverse when the AP wants to sell its inventory of ETF shares. The AP sells the shares for redemption to the ETF manager and receives the basket of underlying securities, which the AP then sells in the market.
Share Price Equilibrium
The creation and redemption process keeps the price of an ETF in a range near the NAV of the underlying portfolio and relies on the AP to takes away any arbitrage opportunities. As with all stocks, the price of a share of an ETF is based entirely on supply and demand. If there are more buyers than sellers, the price of the ETF goes up and if there are more sellers than buyers, the price goes down. If the relationship between the supply and the demand of the ETF shares creates a meaningful difference such that the ETF shares are trading at a premium to the value of the portfolio, an arbitrage opportunity is created whereby the AP can buy the portfolio basket in the market and sell that basket to the fund manager in exchange for shares of the ETF. The process is replicated until enough demand for the portfolio basket and supply of ETF shares nearly completely eliminate the arbitrage and share prices reach equilibrium. It is important to keep in mind that it is common to see slight differences between ETF market values and the values of underlying portfolios. This represents the costs to the AP for its trading activity and is visible in the bid/offer spread of ETF shares.
The difference between the performance of an ETF and the benchmark the ETF tracks.
As an ETF investor you may have come across the term tracking error before. Since ETFs often have a benchmark index that they are meant to replicate or be measured against, tracking error is typically used to measure ETF performance versus the benchmark. As with most errors, the lower the tracking error, the better.
How does it happen?
A few important factors may influence tracking error, including management fees which reduce performance, the fund management’s skill in investing, and market volatility which makes rebalancing the fund’s holdings more costly. Remember, indexes have no trading costs. Tracking error is calculated as the annualized standard deviation of the daily performance difference between an ETF and its benchmark, over a specified time-period.
So what drives tracking error?
Aside from the factors noted above, one big driver for performance differences between a fund and its benchmark is how an ETF manager goes about replicating an index in the first place. This is typically done by representative sampling. Consider any equity index-tracking ETF and the number of securities that make up that index. To perfectly track the index the ETF manager would have to purchase every underlying stock in the index. Doing this would mean buying hundreds of individual stocks which is expensive and time consuming. Many of these stocks may be highly illiquid, adding to the cost and difficulty of purchasing them. The alternative employed by ETF managers is to purchase only a representative sample of stocks that most performs like the index. By doing this the ETF manager can build a portfolio that closely tracks the index while remaining liquid and cost efficient. This is why two ETFs that track the same index may have different tracking errors. The representative sampling for the portfolio is at the discretion of the fund manager. This becomes particularly important when the index represents assets in multiple markets and currencies, making replication that much more difficult.
Net Asset Value
The net market value of the investments in the ETF and an important indicator of its value
ETFs consist of assets (cash, shares, derivatives, bonds etc) and any liabilities. The difference between assets and liabilities divided by number of shares gives us NAV per share which indicates true value of the fund.
NAV is determined at a specific chosen time every day at which point assets are valued. Prices of assets are recorded and aggregated to arrive at the fund’s portfolio value. For example, this would be fairly straightforward for a US listed ETF tracking US equities. As the market closes at 4:00 PM, the fund would value its assets and publish the NAV as of the 4:00 PM close.
This process becomes more challenging if a fund that tracks European stocks trades on a US exchange. NAV for European stocks would be determined at the European market close at 11:30 AM EST. For the rest of the trading day (until 4:00 PM) in US, the ETF would trade with a “stale” NAV as of 11:30 AM. As a lot can happen in four and a half hours, differences between the ETF price and NAV can appear. This process becomes more challenging if a fund that tracks European stocks trades on a US exchange. NAV for European stocks would be determined at the European market close at 11:30 AM EST. For the rest of the trading day (until 4:00 PM) in US, the ETF would trade with a “stale” NAV as of 11:30 AM. As a lot can happen in four and a half hours, differences between the ETF price and NAV can appear.
It is worth mentioning that besides NAV which is available at the end of the day, funds also have iNAV (Intraday/Indicative Net Asset Value) that could be useful in determining the value intraday. iNAV is calculated by a third-party vendor and published every 15 seconds. iNAV is a useful measure and provide even greater transparency but undergo the same drawbacks as NAV. The key takeaway is that as ETFs can own very diverse portfolios and it is important to know their asset value before and after you make an investment. However, as we noted above, the NAV method is not perfect and it is important to understand that while it serves as a useful data point, investment decisions should not be made solely on ETF trading higher or lower than the NAV.
Note: NAVs and iNAVs are calculated in base currency of the fund. If an ETF’s assets are in a different currency, to determine the NAV/iNAV one may need to do a currency conversion to determine whether the fund is trading at premium or discount.
Discount / Premium
When the market price of the ETF is higher or lower than Net Asset Value of the fund.
As ETFs are traded on an exchange just like stocks, the price that is associated with them is the current market price. However, an ETF’s actual value is measured by its net asset value (NAV) at the end of the day, as well as throughout the trading day as intraday NAV. Market price and NAV do not move in lock-step, therefore when the market price of the ETF is greater than its NAV it is said that the ETF is trading at “premium”. And when the market price is below the NAV, the ETF is trading at “discount”.
Generally, during calm markets without low volatility, the NAV and price are relatively close. During more volatile markets, the price moves to reflect the outlook of the market. NAVs take longer to adjust therefore causing premiums and discounts. For example, if an investor wanted to express a view on a healthcare market by heavily buying a healthcare ETF. This would drive the price of the ETF higher. However, this does not mean that the underlying healthcare securities in the same ETF will also move higher. This would cause a premium between the market price and NAV.
Authorized participants (AP) assist in ensuring that ETF’s market price is in line with NAV. In case that material premium or discount arises, the APs can capitalize on it through the ETF creation/redemption process. Creation and redemption exists to bring the supply and demand of the ETF shares together, which ultimately gets the market price in line with NAV. Other than supply and demand that we covered above, other drivers of ETF premiums and discounts are also where NAV trades on a different exchange than the ETF and due to NAV being less liquid which results in larger premiums and discounts.
Lending out securities sitting in an ETF portfolio to earn extra income.
Securities lending is one of those sources of income for fund managers that few outside the towers of Wall Street are familiar with. Securities lending can create profits that you may be missing out on, it can lower your fund’s management fees and it can explain why an index tracking ETF is beating the index.
As the name suggests, securities lending is the act of lending out securities sitting in an ETF portfolio. When lending out securities, borrowers pay a fee which generates additional income for the fund. Why would someone pay to borrow securities, you ask? Think of an ETF portfolio, particularly an equities portfolio tracking an index. The mix of stocks in the index rarely changes and the ETF shares stay mostly idle. Other market participants such as hedgers and speculators may see value in shorting some shares owned by the ETF. The process of shorting a stock and therefore profiting from the decline in the price begins with borrowing the shares from an investor. Once the shares are borrowed they are sold and purchased back at a later date at, hopefully, a lower price. The fee paid to borrow the shares creates securities lending income for the ETF. The fee for borrowing shares ranges depending on supply and demand but it is significant enough for investors to be well informed.
Often ETF managers keep a significant portion of the securities lending income. ETF investors should always read the details of the ETF’s prospectus for details on how securities lending income is distributed. Keep in mind that this income is generated on assets your money was used to buy. In some cases the securities lending income is used to reduce the management fee which can serve as an unexpected benefit to investors. Securities lending income can also boost returns. Going back to our example of an index tracking ETF, assume the ETF tracks the index 100% over the course of a year, including receiving all dividends. The index cannot boost returns through securities lending but the ETF can. This additional income means the ETF has the potential to outperform the index before fees.
Securities lending can be a significant source of income for an ETF and it is important for investors to fully understand how their money is being spent. Although the added income can boost returns for investors, it is often an additional source of revenue for the manager. A few basis points can mean tens millions of dollars in extra income. Details of how the income is distributed are available in the ETF’s prospectus.
The ability to purchase and sell shares easily and at a low transaction cost.
Investors would be wise to always consider the liquidity of securities they buy. Here we discuss some of the main drivers of ETF liquidity and what sets ETFs apart. The ability to purchase and sell shares easily and at a low transaction cost, are important considerations of any investment. As ETFs become more popular due to benefits such as cost-efficiency and transparency, a more robust approach of assessing liquidity is needed on the part of investors familiar with analyzing individual stocks.
Generally, investors new to ETFs use indicators such as trading volumes and ETF asset levels to determine the liquidity of their investment. However, due to an ETF’s unique ability to issue and withdraw shares as a result of the supply and demand (known as creation and redemption), the asset levels and volume metrics become irrelevant. Due to creation and redemption the liquidity of the ETF is defined by the liquidity of the underlying assets of the ETF.
As the underlying assets of the ETF become more or less liquid, this is reflected in the bid/ask spread of the ETF shares. The bid/ask spread is basically the difference between the prices an investor can buy a share of an ETF and sell a share of the same ETF. As a general rule, the tighter the bid/ask spread, the better the liquidity and vice versa. Therefore, it is natural to consider the underlying asset’s liquidity when evaluating ETF liquidity. For example, an ETF that tracks US equities which are a very liquid underlying asset will have better liquidity than an ETF that tracks an emerging markets bond index which could have underlying assets that are much less liquid. The liquidity of the underlying assets will ultimately translate into ETF liquidity due to the creation and redemption mechanism and ETFs will transact at the same level of liquidity as the underlying assets.
When thinking about an ETF’s liquidity the underlying asset’s market schedule is also important. Owning an ETF that owns underlying assets that trade in a market with different hours as the ETF could greatly limit liquidity while also making valuation more difficult. For example, international equities ETFs trading in the US could have a higher liquidity premium built into the price to compensate for the fact that the underlying asset’s market (i.e. Europe, Asia etc.) is closed. Therefore, when investing in an ETF that tracks an index in a market that trades during different hours, for most effective pricing it is best to trade when both of those markets are open (if their hours overlap!).
In conclusion, the most important element when judging ETF liquidity is the liquidity of the underlying assets. Gauges such as daily volume and asset levels of the ETF are not indicative of ETF liquidity due to the creation and redemption mechanisms, which are unique characteristics of ETFs.
ETFs that invest in stocks.
Of the four major asset-classes (fixed-income, commodities, currencies and equities) equities tends to be the most familiar to investors. If you prefer to be a hands-on investor, you probably began with individual stocks. Since ETFs are as easy to trade as a stock, the transition from stocks to ETFs is pretty natural. But not all ETFs own stocks and not all ETFs that own stocks have the same strategies or exposures.
The most basic of equity ETFs is the index tracker. This ETF strategy simply seeks to replicate the performance of an index like the S&P 500 or Russell 2000. These types of ETFs can be a cost effective way to add diversity to a portfolio. Instead of replicating an index other ETFs may own individual stocks with a focus on a particular sector. Such ETFs may concentrate on owning shares of companies in sectors such as energy, real estate or transportation. Although this is still an equity investment the underlying companies may be exposed to particular parts of the economy with returns that don’t correlate to the stock market. For example, an ETF may focus on shares of gold miners. This particular strategy would likely perform well when gold, a commodity, performs well, rather than how well the broader stock market performs. Alternatively, instead of focusing on a particular sector some ETFs may focus on a particular strategy. Such strategies may be as simple as investing in large-cap, high dividend-paying stocks or as sophisticated as allocating assets based on a mathematical model.
Although many ETFs invest in equities the investment strategies and exposures can be wide ranging. The key is to understand what drives risk and return in your portfolio. By researching these details investors can make well-informed investment decisions.
ETFs that invest in bonds.
Of the four major asset classes (equities, commodities, currencies and fixed income), fixed income may be the most confusing. Stocks, oil and dollars are pretty straightforward but with so many different interest rates, maturities and bond issuers, fixed-income can be confusing.
As we have mentioned before, ETFs, at their core, are efficient investment vehicles that can house a variety of different asset classes and strategies. The bond market, although rarely considered by individual investors, measures 1.5X – 2.0X the size of the stock market in the U.S. as well as globally. Every investor seeking to create a diversified portfolio should at least consider whether a bond ETF is worth adding.
Some of the main reasons individual investors don’t consider adding bonds to their portfolios are size and access to the market. Bonds don’t trade on an exchange like stocks do, instead they trade “over the counter” which means they are largely traded by direct communication between buyers and sellers electronically or over the telephone. This and the fact that bonds are not traded in small increments make them mostly limited to institutional investors. Thankfully, ETFs are an excellent tool for allowing investors to gain exposure to these assets easily and at a low cost.
The most basic of fixed income instruments is the U.S. Treasury. Treasuries are debt securities issued by the U.S. Government. The interest rate attached to these securities is often referred to as the “risk free rate” because of the low default risk of the United States. Treasuries are issued with different maturities, from a few months to 30 years. As a general rule, the longer the maturity of the bond, the higher the interest rate will be and the more sensitive the price will be to fluctuations in interest rates. Another common fixed income security is the municipal bond. This security is similar to a treasury but instead of being issued by the federal government, it is issued by a state or local municipality. One of their advantages is that their interest income is not taxed by the federal government. In addition to treasuries and munis, corporate bonds and foreign government bonds are also available via ETFs. Keep in mind foreign issuers may issue bonds in their local currency and not in U.S. dollar which brings with it the risk of changes in exchange rates.
Fixed-income ETFs bring new opportunities and a new level of diversification to the individual investor but they do come with their own unique risks such as changes in interest rates, changes in credit quality of the issuer and possibly, changes in exchange rates. By doing the right amount research investors can ensure they fully understand the risks and rewards that come with investing in fixed income ETFs.
ETFs that buy crude oil, metals and grains.
With the constant flow of news on how much oil producers are pumping, how much gold is being mined and what crops are yielding, many investors wonder how to get exposure to commodities, however taking delivery of gold, wheat, corn or barrels of oil and storing them are impossible for most retail investors.
Before we go further – how are commodities defined?
There are generally two types of commodities – hard commodities and soft commodities. The classification is made on life duration of a commodity. Hard commodities have a ‘long life’ such as crude oil, gold, silver, iron etc. Soft commodities, on other hand, have shorter life such as sugar, corn, wheat, soybeans etc. The ability of a commodity to retain its usefulness after storage influences its pricing. An investor might want to invest in any one of these commodities without having to buy the physical asset. This can be achieved through commodities ETFs.
Back to commodities ETFs…
Commodities ETFs enable investors to gain exposure to commodities without owning the physical commodity. The way ETFs achieve this is either by buying futures or derivatives that are based on the commodity or by owning equities of companies that are involved in the business of sourcing, producing or refining the commodity. By buying the futures contract of a commodity and “rolling” it or selling it as it nears expiration and buying another contract expiring further out in time, the ETF maintains constant exposure to the commodity without ever “taking delivery” or receiving the physical commodity. This strategy would be impossible for a retail investor to achieve alone due to investment size constraints. There are ETFs that track a single commodity (gold, oil etc), or ETFs that track a specific industry such as alternative energy ETFs (alternative sources of energy such as solar, hydropower etc).
Besides the usual advantages of ETFs such as low costs and tax benefits, other advantages of commodities ETFs include a simple and efficient way to invest in commodities without owning the physical asset or entering the complex world of trading futures and derivatives.
Alternative investment strategies more complex than what is seen in typical ETFs.
Alternative investment strategies include multiple or complex asset-classes that may include currencies, real estate, and volatility.
The definition of Alternative ETFs varies widely and it can include any ETFs investing in assets other than simple approaches (long only tracking) to equities and fixed income. Alternative ETFs can relate to asset classes or strategies like the ones listed below:
Alternatives Asset Classes: Allow investing in hard assets such as commodities, currencies, real estate, volatility etc.
Alternative Strategies: approaches that are more complex than simple long only approaches seen in most traditional ETFs. These include strategies such as long and short strategies, leveraged investing in which fund magnifies the exposure of the index to provide higher returns and other.
Alternative strategies were historically difficult for the majority of individual investors to access. This is due to these investments often being managed by hedge funds whose clientele typically include large institutional investors and high net worth individuals with sizeable investment portfolios. Alternatives ETFs allow an investor to gain exposure to the same strategies with lower costs, no investment minimums and better tax efficiency. Traditionally, alternatives were harder to value and less liquid when selling. ETFs have bridged most of these gaps and allowed for easier access to alternatives asset classes and strategies.
With all the benefits and attractive strategies that come with alternatives ETFs, it is important to note that underlying assets such as commodities and currencies can be very volatile. By investing in a particular commodity an investor may be taking a concentrated bet on an asset with its own idiosyncratic risks such as geopolitical risks impacting energy markets or weather patterns impacting crops. In addition, alternative strategies such as levered ETFs expose investors to magnified returns in both directions, and, as the gains get multiplied, so do losses.
In summary, alternatives ETFs are a way to gain diversification away traditional equity and fixed income ETFs in a cost effective way. However, this does come with the need to consider a broader array of risks before investing in alternative asset or strategies.
Leveraged ETFs and Inverse ETFs
ETFs that use leverage or ETFs that provide the opposite returns of an index.
Just as regular ETFs may track an index or asset-class, leveraged ETFs provide magnified returns to the same index or asset-class with a stated multiple (2x, 3x, 4x). This means that if the underlying index moves 1% in a day, the 3x leveraged ETF would move 3%. The way the ETF achieves this is through derivatives (futures and swaps). The benefit of this is that it allows an investor to get a higher exposure to an index without increasing their investment. For example, if an investor wants to buy $1,000 of a 3x leveraged S&P 500 ETF, its performance would match $3,000 of investment in a regular (1x) S&P 500 ETF. This benefit from not having to put up another $2000 to reach an investment objective is the main advantage of leveraged ETFs.
Leveraged ETFs also have inverse leveraged ETF, which effectively magnify the exposure in opposite direction. If in our example above the underlying index moved 1% in a day, the -3x (inverse is denoted with a negative sign) leveraged ETF would move -3%.
It is important to note that the magnified performance objective for leveraged ETFs is met on each specific trading day. However, in the long run, due to the effect of compounding, the performance of an index and a leveraged ETF will diverge from its magnifier (2x, 3x, 4x). Yet, the daily investment objective will always meet the multiplier. This makes leveraged ETFs uncertain long-term investments and more appropriate for short-term holding periods. We elaborate on the technical aspects of this investment in our ETF Advanced section.
Active vs. Passive
Investment strategies that seek to beat the market using research (active) or strateges that seek to mirror market returns (passive).
Given the massive increase in interest in ETFs recently it is no wonder that there has been much talk of “active” vs. “passive” investing. The move towards ETFs is often characterized as a move towards a passive investment strategy and away from an active investment strategy. The going theory appears to be that many ETF investments tend to be in index tracking ETFs where the portfolio mix is largely decided for the portfolio manager or in ETFs with asset allocation models that are largely automated such as factor models. This is understandable given the migration of investors from mutual funds which often have active portfolio management teams.
Two questions naturally arise: In the case of index ETFs, if the asset mix of the index is known before buying the ETF, is the investment decision truly passive? In the case of asset allocation models, if the asset allocation model was designed by a human with certain risk and return parameters in mind, is the allocation truly passive?
Index tracking is the traditional ETF strategy and is one that many investors have moved to given the lower fees and better performance compared to those of many mutual funds. Indexes typically have well-published, liquid components that make them easily replicated by ETF managers and transparent to investors. In addition, historical returns are known with easily accessible data. With the plethora of information available, investors are able to make a well-informed, active decision. Furthermore, it is important to keep in mind that to more efficiently manage an index, ETF fund managers typically use representative sampling to replicate the performance of the index without owning each stock in the index.
ETFs that rely on quantitative asset-allocation models such as smart-beta or factors differ from traditional funds which typically rely on human research teams to pick investments. These models tend to focus on specific attributes of potential investments and their historical performance relative to broader indices. By taking this approach, portfolio managers seek to provide a better risk-adjusted return relative to the broader market. This approach to investing is active in that it involves many choices in building the right model with many potential parameters for the fund manager to select from.
In summary, the terms active and passive can misleading. Whether the strategy is replicating the performance of an index or selecting assets using a quantitative model, many decisions by the fund management team will influence performance making these strategies anything but passive.