Another important topic in the ETF investing space is understanding the differences between the passive and active versions of ETFs. There are a variety of differences between active and passive ETFs and if investors buy into them blindly, without understanding at least some of the differences, they could be exposing themselves to unintended risks.
Disclaimer: This article does not advocate for one type over the other. They both have their benefits and can coexist within a portfolio. For any sort of investing advice, please do your own homework and consult with a financial adviser if you have one.
What is an Active vs Passive ETF?
The most common ETFs are passive and they are constructed to follow an index. The holdings within these ETF portfolios are updated at regular intervals (e.g. quarterly) and they also tend to follow buy-and-hold trading strategies as they seek to replicate the returns of the indices they follow. Active ETFs, as the name implies, have fund managers at ETF issuers who actively manage the composition changes of these ETFs.
What are some of the differences?
Passive outperforms Active but not everywhere
Whilst it’s typically cited that passive outperforms active investing, it’s not true for every fund manager and it’s also not true for all sector types. The ASX distinguishes between funds which are index-tracking and those which are not. Using this information along with the knowledge that all Chi-X funds are actively managed we can compare performance. As we can see below, there are ETF categories where non-index tracking ETFs have outperformed when we look at monthly returns going back to 2019. The past performance does not guarantee future returns but it is worth comparing.
Note: the groups shown here are a consolidation of the listed ETF categories shown by the ASX and Chi-X where the various Australian ETF categories (e.g. Australia, Australia Sectors, Australia Small/Mid cap) are grouped into 1 larger sector. For the purpose of timing for this article, a baseline level of growth was not added but analysis of this nature can be added in future articles.
Some ETFs not as diversified as you think
Diversification certainly is in the eye of the beholder but some passive ETFs might not be as diversified as you think. Recently, I did some analysis (Digging Deeper into ETF Holdings) that showed the average weight across the top 10 holdings of ETFs that share holdings data (156 of them) was 44%. This is across an average of 7.4 holdings. Passive ETFs can offer lower cost diversification than active but if you don’t look at the data you may not be as diversified as you think.
Varying levels of transparency across different ETF types
As above, passive ETFs offer a better view into what their underlying holdings than active. The latter does provide holdings data but on a delayed basis (e.g. quarterly). This is fair since the composition of these portfolios is the fund managers IP (intellectual property) and full transparency would not make much sense for them.
Access to ETF holdings can be gained through looking at ETF issuer websites and downloading PCF statements. Some information is also on Yahoo Finance (but only top 10 holdings) whilst other, paid services, offer more insights.
Lower fees, but lower potential returns
Passive ETFs have lower costs than active ETFS (as can be seen via their MER or Management Expense Ratio) but, passive ETFs are built to track an index, not outperform it (as seen above in our performance section). Whilst not all active ETFs outperformed their benchmarks, they are less restricted on performance as their mandate is not simply to track an index.
Valuation and Exposure risks
Passive ETFs have more potential to be exposed to negative valuation risks than active ETFs. This occurs when they have to follow a particular holding change in an index they follow such as when ETFs following the S&P 500 had to adjust for Tesla being added to that index. Active ETFs have more manoeuvrability to avoid this if they choose.
Furthermore, passive ETFs are less able to adjust to changing market phenomena such as rising interest rates or the changing tide going against the technology sectors. Active ETFs give investors access to fund managers who can navigate these sorts of market headwinds.
Passive ETFs, due to needing to track indices they follow, can lead to investors needing to make more direct portfolio decisions themselves.
When market issues arise, an advantage of active ETFs is that they can also hold cash to manage the overall risk of the portfolio whereas passive funds are less able to take advantage of such opportunities.
Liquidity refers to the ability to quickly and easily buy and sell a security. If a security cannot be sold easily, then it is considered illiquid. ETFs are a popular investment vehicle as they offer access to diversified, fund-like performance but are more liquid as they trade on exchanges. We can see some signs of ETF liquidity in the bid-ask spread where tighter bid-ask spreads often signal more liquidity and wider spreads can mean less liquidity.
ETFs are often considered similar to stocks but in doing so it is wrong to assume that trading volumes are proxies for liquidity. Whilst stocks can have fixed volumes in circulation, ETFs (through creation, redemption mechanism) have their liquidity mainly affixed to the liquidity of the underlying holdings that make up the ETF. This means that an ETF that has low volumes can actually be highly liquid, and vice-versa.
ETF liquidity issues were on show in a recent article by the Financial Times ("Concerns grow over ETFs’ illiquid holdings"). They talk about how, when market sell-offs occur, illiquid ETFs can be prone to being sold far lower than the current market prices indicate. Also, due to retail investors being far less privy to the liquidity of the underlying holdings of an ETF (as they have less access to data and tools that institutional traders have), they are far more prone to liquidity risk when buying ETFs.
Factset, the financial data firm, developed a methodology of flagging ETFs with liquidity issues by looking at how much a 5% sell-off in an ETFs FUM would equate in terms of the average daily volume of that ETF. What they found was a high underlying volume per unit figure indicates an adverse price impact is more likely, particularly with funds that hold outsized positions in less liquid markets. In the example they looked at the iShares Global Clean Energy ETF. If investors sold out enough to drive redemptions to 5 per cent of AUM, the necessary portfolio trades would equal 36.44 per cent of their recent median trading volumes.
Across Australian ETFs, passive/index tracking ETFs have shown to have lower liquidity than their active ETF brethren.
Both active and passive ETFs can lead to correlation related risks for investors. If multiple ETFs are held in a portfolio and the underlying holdings are replicated across those ETFs (e.g. there is a high level of similarity across those ETFs), then investors may be paying more fees for the same level of performance (depending on the weightings of those holdings.
Within an individual ETF, if the holdings have shown strong levels of correlation, this can remove the positive effects of diversification that one would expect from an ETF. Investors with access to ETF ratings that showcase these correlation statistics may choose to find other ETFs with less correlated holdings but for investors without this information, they may miss out.
Correlation comparing ETF vs ETF performance is also something to be mindful of. It's unlikely that an investor will buy both the IOZ and STW ETFs as they both track the ASX 200 but buying a core fund (like IOZ and STW) along with a more sustainable fund like FAIR could be something an investor does not think twice about as they appear in different categories and have different goals. However, FAIR and STW are 93% correlated (when looking at their 1-month returns since 2018 - see below). In this case, an investor would be paying extra transaction and management fees for similar returns, effectively reducing their own potential returns.
Other Active vs Passive observations
There are some other common market myths about the active vs passive debate that also deserve to be looked at. Damian Hoult of Basis Global Analytics highlighted some of these in this LinkedIn article: https://www.linkedin.com/pulse/active-passive-debate-really-something-more-insidious-damian-hoult-1d/.
The 3 areas explored are:
SPIVA Scorecards and their misuse
William F Sharpe’s “Arithmetic of Active Management” and derivatives of this
On SPIVA – it’s a commonly used scorecard from S&P and often used to create statements like:
The EOY 2017 SPIVA scorecard for Australian active equity funds shows the majority have underperformed the S&P200 index over 1, 3, 5 and 10 years, net of fees.
Yet Hoult also highlights that the following are also mathematically true
The EOY 2017 SPIVA scorecard for Australian active equity funds shows the majority have outperformed the S&P200 index over 1, 5 and 10 years, net of fees.
The EOY 2017 SPIVA scorecard for Australian passive funds shows close to 100% have underperformed the index over 1,3, 5 and 10 years, net of fees.
There are a variety of reasons for these anomalies such as the use equal weighted returns which make active equities look like underperformers on the one hand but when measured using returns on actual dollars, can produce outperformance.
On Sharpe Assertions - these are assertions which state that given equally returning funds, active management will return less after fees. Passive managers are more restricted in terms of what they can hold so over time, active managers can outperform by margins that exceed any highlighted cost differences.
On Costs – looking at transaction costs there are factors that it does not measure and these should also be considered as part of risk assessment. This includes reversion, market risk, liquidity risk, capacity risk, volatility risk, timing risk or incomplete and unexecuted orders, all of which, Hoult states can impact performance significantly.
Seeing which is which on ASX and Chi-X
To see which ETF is active or passive, you can do that by looking at each of their fund information pages that you can access on the ETF issuer websites.
Another way to do this is by looking at the ASX Fund Statistics files they produce each month. They have a field in there called “Type” and where it is listed as an “MF” – or managed fund, it means that the ETF does not track an index. The level of how much that ETF is actively managed is not shown in the ASX data but you can get a good idea from that to begin with. For Chi-X, all of the ETFs listed there are actively managed so when you see ETFs that are Chi-X listed, you’ll know what they are.
For the ASX fund statistics page you can see that here: https://www2.asx.com.au/issuers/investment-products/asx-funds-statistics
For Chi-X, their monthly reports are here: https://www.chi-x.com.au/funds/monthly-reports
Whichever way you cut it, both active and passive ETFs offer great benefits but also have some costs attached to them. There are clear benefits for active as there are for passive and choosing which one is right for an individual investor depends on their particular circumstances and risk/return criteria.
There is much more than meets the eye when it comes to ETF investing and hopefully we've shed some light on passive and active differences in this article. For further reading on this and other ETF topics check out the following links:
Alignment Systems on ETF liquidity and liquidation risk
Quill Group on Active vs Passive - https://www.quillgroup.com.au/blog/active-vs-passive-investing/
J.P. Morgan research - Debunking Myths about ETF liquidity - https://am.jpmorgan.com/blob-gim/1383272223898/83456/1323416812894_Debunking-myths-about-ETF-liquidity.pdf