Index funds can be a nice, conservative way to earn a steady return. But actively managed ETFs can help you beat the market. Should you try?
Typically, investors and even financial advisors refer to ETFs as index investments. However, Barron’s recently reported that the number of actively managed ETFs more than doubled in the last two years, which means investors need to be more vigilant about what products they’re actually buying.
Let’s review the basics. The first U.S.-listed ETF, the SPDR S&P 500 ETF Trust (SPY), was launched in 1993. It’s very much alive and well today, with $428.1 billion under management. As its name suggests, the ETF tracks the S&P 500 index of large-cap U.S. stocks.
Later, ETFs tracking other popular benchmarks were launched. For example, the Invesco QQQ Trust (QQQ) was created in 2002.
This fund replicates the Nasdaq 100 Index, which includes the 100 largest non-financial companies listed on the Nasdaq, weighted according to market capitalization.
This ETF now has $206.9 billion under management.
Index ETFs like these are a good way to include a primary asset class, such as domestic stocks, in your portfolio. Not only is the asset neatly packaged up for you, but you’ll pay low fees, as index funds have no discretionary trading, meaning trading costs are quite minimal. In addition, there’s no need to pay a management and research team to uncover the best stocks to buy – or which to unload.
According to a March 2021 report from the Investment Company Institute, expense ratios of index equity ETFs were 0.18% last year, down from 0.34% in 2009. That was unchanged from 2019.
The average index bond ETF expense ratio declined by one basis point to 0.13% in 2020. That’s down from a recent peak of 0.26% in 2013.
Despite the cost advantages of index funds, and the ease of implementation in a portfolio, actively managed ETFs are growing more popular. According to Morningstar data, actively managed domestic ETFs reeled in nearly $275 billion in net assets in September. That’s up 96% from the year-earlier figure of $140 billion.
ETFs in general are benefiting from a shift away from mutual funds, as investors appreciate the more advantageous tax treatment, as well as the ability to trade intraday.
However, with some recent bouts of market volatility, the ability to target even more specific investment strategies has made active ETFs more appealing.
While the idea of trying to top a benchmark is what attracts many to active investing, it’s important to understand if benchmark-beating returns are even necessary in your situation. For example, if you analyze the expected return and risk levels that will generate the income you need, there’s no reason to take extra risk just for the bragging rights of “beating the S&P 500.”
Don’t get me wrong: I fully understand that most Cabot readers and subscribers enjoy finding undervalued investment ideas, or growth stocks with the potential to increase by double, triple or even quadruple digits. That’s a worthy endeavor, as long as it’s in the context of your broader financial strategy and you’re not blindly chasing gains by layering on dangerous amounts of risk.
One Actively Managed ETF to Consider
Active ETFs have advantages that pure index funds don’t. For example, some managers can respond fairly quickly if market conditions change. For example, it’s not uncommon to see some active funds increase their cash positions in a downturn. While that can be a prudent strategy for preserving capital, it can also mean investors are paying a manager to hold cash – something investors could easily do on their own, without forking over a percentage.
Active ETFs make sense if you are looking to bolt on a particular theme or thesis that’s best achieved outside of an index. Perhaps the most salient example in the past year has been the ARK Innovation ETF (ARKK), which has $21.62 billion under management. It advanced a whopping $152.82 in 2020. The fund has been in a correction for most of this year, but still boasts a one-year return of 18.44%.
According to fund manager Ark Invest, this ETF “seeks long-term growth of capital by investing under normal circumstances primarily (at least 65% of its assets) in domestic and foreign equity securities of companies that are relevant to the Fund’s investment theme of disruptive innovation.”
This ETF has an expense ratio of 0.75%, due mainly to frequent trading as well as costs of a research team.
So what is the benefit of investing in an actively managed ETF over a mutual fund, or over a collection of single stocks you’ve picked yourself?
For one thing, it’s undeniably easier to make one investment in a basket of securities if you are trying to achieve one particular goal, such as finding disruptive and innovative companies. That’s an advantage over trying to construct your own“fund” by picking stocks.
When it comes to choosing an active ETF over an active mutual fund, the lower expense ratio of ETFs remains a compelling argument.
The bottom line with any investment selection should always be: Does this fit with my investment philosophy or is it earmarked as a way to potentially add alpha? Perhaps it’s just “fun money” that you can essentially gamble with and not affect your chances for a successful outcome.
As long as you understand where an active ETF fits into your broader investment plan, and as long as you understand potential risks, these can be very productive portfolio additions.
Do you own any actively managed ETFs? Tell us about them in the comments below!