In our last lesson we looked at Smart Beta ETFs. These are rules based ETFs that follow indexes designed to meet certain investment objectives. Whilst investment fees of smart beta ETFs are higher than passive ETFs, their rules based approach tends to make them fairly low cost still. We called Smart Beta ETFs ice cream with chocolate topping. But what if you’re looking for some Artisan Gelato, where the gelato master has total control on the ingredients to deliver a totally unique product? This is where Active ETFs come in.
You may be thinking by now that Smart Beta is the perfect ETF type, with fairly low fees and access to a broad range of investing strategies. Well this is true, but there is a risk with Smart Beta’s rules based approach.
Often the rules developed are based on historic modelling. This may show the Smart Beta ETF outperforming historically, but history does not always repeat. As a result the assumptions built into the index may not apply.
Additionally, companies may meet the investment criteria of the index on the surface, but there may be an underlying factor that a sensible person may say means a company no longer meets this criteria, even it the rules are met. For example, in 2016, the mining sectors was in the doldrums. Most big mining companies had yet to cut their dividends, meaning they got included in many of the high dividend yield indexes. Mining companies are not known for high dividend yield, and eventually re-set their forecasts and cut their dividends Most analysts forecasts these cuts, yet the companies still ended up in the High Dividend ETFs because they met the rules at the time.
If the above worries you, then there’s two approaches you can take. Invest with the crowd via passive ETFs, or let the experts make the investing decisions, via active ETFs.
Active ETFs are also known as Exchange Traded Managed Funds (ETMFs). Active ETFs have their roots set in the traditional managed funds industry. We looked at this in the first lesson in ETF University, so we won’t go back into the details here.
Essentially, the investment manager and their team of analysts make all the investment decisions in an Active ETF. They may be still constrained by some rules, for example, they will only invest in Australia, or can hold no more than 5% in an individual position, but other than that the manager has control of what they invest in. Each manager will have their own methodology they believe will deliver them outsized returns.
Active ETFs tend to have higher management fees than passive or smart beta ETFs. Investment analysts don’t come cheap, so higher fees result. Many active ETFs also charge a performance fee, where if their performance exceeds a certain hurdle (generally the benchmark they track themselves against), they are able to earn a percentage of these outsized returns as management fees. This is generally 10-20% of any excess performance.
The fund managers argue that this aligns investors interests and their own interests, where both are rewarded if the fund manager’s skills allow them to outperform.
Now that you’ve learned about all three ETF management types, you might think Active Management is going to deliver you the best returns using the skills of the highly educated investment managers to beat the indexes or rules based indexes in passive and smart beta ETFs.
The harsh reality is that very few active managers actually outperform over the long term. The stats vary depending on the source, but most analysis shows 75% of managers underperform their benchmark over the long term. Certainly some active managers do outperform, so it is important to not tar the whole active management industry with the same brush. For example, Warren Buffett has been one of the most successful active managers in the world, and investors in his Berkshire Hathaway company have done incredibly well over the years.
Because of this, it is important investors go into investing in Active ETFs with their eyes wide open, and ensure they choose a manager with a strong track record.
Now we’ve looked at the 3 management types of ETFs. Hopefully you’ve had a look at the ETF Watch Fund Database and found some ETFs you want to buy, Next it’s time to look at how you buy ETFs and some of the things to look out for.