Max Pacella
Investment Analyst
Macro & Markets
12 May, 2021

Funds have been trading on listed exchanges since 1990, beginning life as ‘index trackers’ which sought to replicate the movement of the underlying index. From a single ETF listed on the Toronto Stock Exchange, there are now over 2,200 ETFs listed in the United States alone – the SPDR S&P 500 ETF (SPY:NYSE) alone holds $367 billion USD.

With global exchange traded fund (ETF) assets exceeding $7 trillion USD under management, it seems the investor demand for ETFs has been going from strength to strength over the last 30 years.

But what exactly constitutes an ETF, what characteristics do they offer as an investment vehicle and how can they be employed in a portfolio?

Today we will explore ‘passive’ versus ‘active’ ETFs, their respective usage from an overall portfolio perspective and how these different strategies can work together to deliver a better risk-adjusted outlook for overall holdings.

Benefits of ETFs

Traditionally, ETFs have been considered advantageous over an unlisted managed fund due to their low cost and ample liquidity – but this is not all that this structure can offer.

Like any managed product, the advantage of an ETF is that you are able to express an investment thesis without needing to individually manage holdings; taking the example of an ‘index tracker’, you may be bullish U.S stocks, so you would buy the S&P 500 ETF rather than buy all 500 stocks and manage their positions.

Because ETFs can be large baskets of stocks, they can add a higher level of diversification within the portfolio than a more concentrated strategy.

Likewise, you can get exposure to an entire sector rather than just taking a risk/position on a few companies, such as the VanEck Australian Resources ETF (MVR:ASX).

They also offer more transparency (generally) than an unlisted fund – here on the desk we can go to Bloomberg and pull up the holdings for most large ETFs and scrutinise the individual holdings/weights, unlike an unlisted unit trust.

There are also simply more of them – it’s much easier to express an investment thesis on an obscure region or sector through an ETF than it is to find a manager seeking exposure to that theme.

Active versus Passive

When many investors think of ETFs, they just think of funds which track a particular index, attempting to re-create a certain basket of stocks with no view on the positions themselves.

But this does not constitute the entire universe of ETFs.

This is one of the two ETF strategies known as “passive”, meaning there is no active management of the portfolio, only a pure replication of what the index is doing. Passive ETFs are more akin to a long-term time horizon, and given they track large baskets of stocks, they endear themselves to a wider macroeconomic overview as opposed to a stock-specific view. The largest ETFs in the world consistent almost entirely of passive index trackers, and have long been favoured by retail investors for a low cost equity exposure.

On the other hand you have “active” ETFs, which are more akin to a traditional managed fund in a listed form – these ETFs can trade in and out of securities, take a view on the market and hold all the regular investment strategies and philosophies of their unlisted counterparts.

The active ETFs with the most public attention over the last year would likely be Cathie Wood’s ARK ETFs, more specifically ARKK:NYSE – but there are also listed versions of existing unlisted funds, for example the ActiveX Ardea Real Outcome Fund ETF (XARO:ASX).

On balance, active ETFs tend to be more expensive, since you are paying an active management team who seek to outperform the market, rather than replicate it – and generally hold a smaller portfolio of securities for a similar reason.

They are not always a perfect re-creation of the unlisted version, and there are still strong merits to holding the managed fund in a more traditional unit structure – but the aim of the listed version is generally to create liquidity and transparency for investors.

This begs the question: “which should I use?”

Portfolio Construction

Both passive and active ETFs can be used to complement an existing portfolio, or be used to construct an entirely new one, depending on your investment thesis.

To quote most university economics lecturers, “assuming that markets are efficient in the long run”, traditional logic would dictate that over a period of 5-10 years, passive ETFs should outperform the wider active market since the index would ‘do the leg work’. In other words, a passive holding is a long-term, macro investment.

On the other, in the short-to-medium term there are always market inefficiencies, areas of growth or lag which the market has either not noticed or not priced in to the correct extent – this is where active management can generate returns in excess of the market (known as “alpha”) and be beneficial to the portfolio.

In our recently launched Mason Stevens Dynamic ETF Portfolios, we use a blend of the two strategies to capture both long-term beta and short-term alpha; selecting managers and strategies based on both top-down macroeconomic views (long-term, passive) and tactical/structural sector tailwinds (short-term, active) to seek the best risk-adjusted returns.

One principle that investors should keep in mind when choosing passive versus active is which strategy/benchmark you are taking exposure to;

  • Taking exposure to a large, well-researched index like the S&P 500 is suitable for passive investing because over the long-term this index should hypothetically represent the overall economic health of U.S businesses.
    • For a global example, the Vanguard US Total Market Shares ETF (VTS:ASX) tracks a broad index of U.S securities for a diverse exposure to North American equities.
    • In taking a position on domestic large-cap equities, it would be appropriate to buy a passive fund such as iShares Core ASX 200 ETF (IOZ:ASX) as a broad bullish thesis on Australian business strength.
  • Taking exposure to small or more specific indexes – here we will use the example of an emerging markets index – lends itself more to active since this market is constantly inefficient and less researched. You may be bullish Asia but bearish Latin America, so taking a passive index would not allow you to express a specific investment thesis with a broad index.
    • For example, the BetaShares Legg Mason Markets ETF (EMMG:ASX) is a listed managed fund which takes an active strategy in selecting companies within emerging markets.

Exchange Traded Opportunities

With such a wide universe of products and strategies, ETFs are a compelling way to get exposure to a multitude of markets and strategies, across many asset classes.

This gives investors ample opportunity to express their particular views throughout a single exposure to an entire portfolio of ETFs.

As always, proper risk consideration and asset allocation should be taken into account when building any portfolio (be it equity, fixed income or multi-asset) – once you have that sorted, ETFs can then play an important role in expressing one, some or all of your exposures through manager and strategy selection.

It’s a wide universe of options out there, and with more assets flowing into these vehicles each year you can only expect it to get bigger with time – there’s an interesting investment idea, maybe there’s an ETF which tracks other ETFs?

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.