How The Active vs. Passive Debate Boosts ETFs

When considering where to invest, exchange traded funds (ETFs) or otherwise, what’s better: active or passive?

If active managers are under-performing the market, people think indexing would be the way to go, but if active managers outperform the market then those same people would probably say the reverse, remark Christopher Philips and Francis Kinniry Jr. for IndexUniverse.

In a given period, the performance of an active manager varies. It may be attributed to overall trends in the markets, or market cycles, and fund manager strategies, which varies in market capitalization, price/earnings and price/book ratios, and positioning.

During periods of elevated performance deviation in opposing market segments, like large- vs. small-caps or growth vs. value, there tends to be a greater distribution of returns in active management and a more distinct difference in performance relative to the market. When deviations are milder in the long term, fund styles have less of an impact and investors would look to costs.

Phillips and Kinniry looked at a variety of factors and technicals before determing that the overall effect was that active management under-performed when an index was performing well, and outperformed when an index was weak.

But an investor should note the rationale behind active management. There is an opportunity for higher returns compared to a benchmark, but it comes with higher average expenses, potentially increased tracking error and risk of under-performing. Indexes try to mirror a benchmark with lower expenses and relatively smaller tracking errors. Therein lies the benefit of ETFs.

For many investors, it’s easier and more cost-effective to just buy the index and follow along with it. Even better is having an entry and exit strategy to dictate when you’re in and when you’re out.

There are also actively managed ETFs available now, which come in a less expensive form than similar-style mutual funds. Mutual fund enthusiasts feel somewhat protected that active ETFs will not pose much of a threat to the industry already in existence, and that these types of ETF still face a number of bumps in the road before they will be embraced by all investors. But active ETFs are still in their early stages, and we’ve been in challenged markets. They’re going to be a force to be reckoned with when a recovery begins.

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