Active Vs Passive ETF – Which Is Better To Invest In?
Since the start of 2020, interest in investing has grown significantly in Singapore and globally. During meet-ups with family and friends, we would inevitably find ourselves discussing topics related to the financial markets. From the latest moves by Elon Musk, to a deeper analysis on which stocks we are looking at, and even whether Dogecoin is a must-have in our portfolio!
But don’t worry this isn’t another one of those conversations.
Instead, we’re going to look at ETFs.
For many new investors, ETF investing is one of the easiest ways to get started investing. And while there are many different types of ETFs out there, they can be broadly divided into active ETFs and passive ETFs.
Read Also: Complete Guide To ETF investing in Singapore
What Is An ETF?
One of the best analogy to understand an ETF is to compare it to buying eggs individually vs buying them in cartons.
Take an index ETF like the SPY for example.
By investing in SPY, an ETF that tracks the S&P 500 index, you are essentially investing into the top 500 companies in the US with a single investment, including Amazon, Google, Microsoft and more. This is different from just picking stocks one by one.
ETF investing gives you broad diversification so the risk is greatly reduced. However, returns can only be expected to be market average since you are pretty much investing in the entire US market itself.
ETFs are also not limited to stocks and can include other assets as well. This means you can have gold ETFs, bond ETFs, REITs ETFs and more.
Active Vs Passive ETF
As mentioned earlier, even though there are many different ETFs we can invest in, there are 2 main types – active vs passive ETFs, with the core difference being how the components within the ETFs are decided.
Passive ETFs tend to track a benchmark or measurement. For instance, SPY which we’ve discussed earlier tracks the S&P 500 index which measures the stock performance of the top 500 companies in the US markets.
The index itself may change from time to time (e.g. the top 500 US companies in 10 years’ time will likely not be the same as the top 500 US companies today). However, SPY being an S&P 500 index ETF will always be tracking the same index. In other words, it follows the S&P 500 as a benchmark.
On the other hand, we have active ETFs which are more similar to mutual funds and unit trusts albeit with some differences.
Editor’s note: ETF stands for exchange-traded funds and as the name suggests, they trade actively on stock exchanges, unlike mutual funds or unit trusts.
A good example of active ETFs are those managed by ARK, probably one of the most talked-about ETFs today. There are currently eight ARK ETFs – with six of them actively managed by its fund managers and two of them tracking an index.
Ark’s flagship ETF is ARKK, which is actively managed. As explained, the components within the ETF do not track a fixed benchmark. Instead, they are decided by the fund manager(s) managing the ETF.
In the case of ARKK, the team behind ARKK can make certain changes to existing composition whenever they want to base on their own investment process.
Of course, there are still some “rules” they have to adhere to when making portfolio adjustments. For instance, before the latest changes, ARK ETFs had a 20% cap on the amount of shares they could own of a company.
It is also worth noting that active ETFs (given the active nature) tend to have much higher fees as compared to passive ETFs. This is because the cost is higher too given the need for active fund managers to make decisions on the constitution of the ETF, rather than simply replicating an index.
Active ETF Vs Passive ETFs: Which Is Better?
Most investors would also be familiar with the spectacular performance Ark’s ETFs achieved last year. For one, their flagship ARKK ETF was easily up more than 100% in 2020 alone, while the broad US market was only up slightly above 15% (based on S&P 500 index).
From this, it may be tempting to just dismiss other ETFs like SPY and go for ARKK.
However, it is important to understand that past results do not necessarily reflect future performance.
In fact, studies did have shown that most actively managed funds actually fail to outperform the broad market over a long investment horizon.
Hence, for investors who are looking for above-market returns through active ETFs (though the odds are not in your favor based on history), it is important to not just focus on past performance, but also on the fund’s investment philosophy.
This means performing due diligence on the investment approach the fund takes when making stock selection to ensure that the approach is comfortable and aligned with you as an investor.
For example, Ark’s research and investment process focus on disruptive innovation of artificial intelligence, robotics, energy storage, DNA sequencing and blockchain, riding on what they think are secular growth trends moving forward.
“Over time, innovation should displace industry incumbents, increase efficiencies, and gain majority market share, offering growth opportunities for investors. More importantly, disruptive innovation impacts and concerns all of our lives and changes the way the world works.” – Catherine Wood, CEO of Ark Invest.
Fun fact: Did you know that ARK’s funds are also invested in SPACs? Is that something you’ll be comfortable with as an investor?
Passive ETFs on the other hand focuses on gaining broad exposure to a specific asset, market or sector. Using the SPY example again, the investment basis is to ride on the long-term growth of the US economy. As technology advances, population grows and productivity increases, businesses are expected to do well over time so investors can reap the rewards.
The purpose of this discussion is not to encourage or discourage any specific ETF investment, but rather to highlight the key factors and differences investors should consider.
There are many ways to invest in the stock market and there is no one-size-fits-all strategy for everyone. It all depends on your individual preferences and needs as an investor.
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