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January 02, 2018 at 07:00 PM
An investment management behemoth practically synonymous with passive investing recently made headlines by announcing what the company calls its first actively managed ETFs. But, how “active” will these ETFs be?
Generally, there are three broad categories of ETFs: passive, smart-beta and active. The vast majority are passive.
They’re designed to replicate an index and typically provide “symmetrical returns” that track the return of their correlating index, for better — as may be the case in bull markets — or worse, as can be the case with bear markets. They tend to be lower cost because there is no “active” risk-management component.
While there are thousands of passive ETFs, only about 100 ETFs are active. There are varying degrees of “active,” which can make it difficult to identify truly active products. Broadly speaking, an active ETF’s underlying portfolio allocation is managed periodically and is not tied to an index.
A common misconception of active ETFs is that they are all supposed to beat the market or passive ETFs. Rather, some active ETFs aim to help investors achieve their long-term goals by limiting bear market losses while attempting to capture most bull market returns.
“True active” ETFs therefore may have active security selection. They typically do not track a benchmark and may raise cash or use other strategies to mitigate risk. Hence, active ETFs have truly active management.
In my opinion, smart-beta ETFs fall somewhere between passive and active. They seek to follow a passive index while using alternative weighting rules focused on providing a slightly different outcome than traditional broad-based index passive ETFs.
Smart-beta ETFs typically utilize one (i.e. beta) or multiple “factors” that are applied to the index to provide an “active” security selection.
Therefore, these ETFs are not fully passive since these weighting strategies can provide some risk mitigation. However, they are not fully active because they are designed to track an index, and their holdings are rebalanced periodically — typically quarterly or annually.
