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Industry Icon Introduces Active ETFs

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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.

The new Vanguard ETFs, which bill themselves as “active,” appear to be smart-beta products by prospectus because 80% of the product will be invested under normal circumstances.

And, while Vanguard wrote in an August 2015 white paper that “smart-beta indexes should be considered rules-based active strategies,” the differences between smart-beta and active are significant enough that conflating the two is inaccurate and could potentially be misleading to investors who think they are getting what I would consider a fully active ETF.

Because there’s no real industry consensus on what “active” means, it’s up to investors to do their own research on which ETFs are truly active.

Advisors shouldn’t take for granted that their clients know the difference between passive, smart-beta and active ETFs.

They need to make sure clients understand the advantages and disadvantages of each and the role they play in a portfolio. They need to convey the expected outcomes for different types of ETFs and how to monitor and benchmark their performance.

Perhaps most importantly, I recommend that advisors tell clients that the adage “you get what you pay for” applies to ETFs.

Investors who use passive ETFs may balk at the higher fees imposed by active ETFs without realizing that overuse of passive ETFs can expose their portfolios to a greater risk of large losses, potentially having lasting effects on their financial future.

The only way to avoid disappointment is to understand the investment objective and principal investment strategies that the product is required to deliver by prospectus. And, the reason some ETFs — even the so-called “active” ones — have such lower fees is that they may lack truly active risk mitigation.

To me, active management is more than a marketing scheme. It is a tool that can be used in tandem with passive or smart-beta to limit losses, enhance returns or mitigate risk. Know what you own.