Arguably one of the biggest debates in investing these days comes down to active vs. passive management. Over the years, passive investment funds have made sure that independent research, conducted by active fund managers, to beat the broader markets remains a difficult sell to investors. As a result, many investors – both retail and institutional – are giving up their active funds and focusing on owning index funds. The explosion of ETFs has only exacerbated this fact.
But investors may want to rethink that idea.
Thanks to the growth in active ETFs, many of the hurdles that face active management could be eliminated. As a result, the debate over passive versus active could be ending. The reality is that our portfolios could benefit from both.
Be sure to explore our Active ETFs Channel to learn more about them.
The High Fee Hurdle
It’s no wonder why investors have flocked to passive index ETFs like the SPDR S&P 500 ETF (SPY) over the years. Numerous studies have shown that so-called passive investments that track an index outperform active strategies over the long haul. As a result, investors have plowed nearly $7.7 trillion into the fund type globally.
The reason unearthed in the various studies dealing with the outperformance of passive funds comes down to two big fronts.
The first comes down to costs. Passive index funds and ETFs are some of the lowest cost-investment vehicles you can own. For example, the previously mentioned SPY only charges 0.0945% in expenses. That’s under $10 per year for a $10,000 investment. As a result, they don’t need to overcome their costs to generate a return. However, active managers charge way beyond that in terms of expenses. The current asset-weighted expense ratio for active funds according to Morningstar is around 0.78%.
An active fund with a 1.25% expense ratio needs to make at least that much in order to produce a positive return. Because of their lower expense ratios, passive funds have been able to beat active ones in most scenarios.
Secondly, poor stock picking hinders active results. The American fund system is designed to pay active managers based on fund size. The more assets you have under management, the more in fees – even if they are low – you’re able to generate.
The issue is that once an active fund becomes a certain size in terms of assets under management, it becomes harder for managers to buy enough stock in a company to make a real difference before frontrunners catch on. If you’re running a $5 billion fund, you can’t go out and buy shares in a small-cap biotech firm. This means investors are left buying solely mega-caps such as Apple (AAPL) or other big stocks in the S&P 500. Quickly, they become closet index funds. Adding in their high fees, they then lose out to passive investments.
Active ETFs Solve These Issues
Most of the issues with regards to underperformance by active funds are focussed on mutual funds. Active ETFs on the other hand help to solve some of the problems.
For one thing, they are way cheaper to own than similarly active mutual funds. Take for example, the T. Rowe Price Dividend Growth ETF (TDVG). It charges an expense ratio of 0.50%. The T. Rowe Price Dividend Growth Mutual Fund (PRDGX ) charges 0.68%. Both funds are managed by Thomas J. Huber, have the same mandate and are virtually copies of each other. But the lower expense ratio on TDVG is more likely to make it perform better than PRDGX over the long haul. Better still, TDVG doesn’t have to hold cash for redemptions like PRDGX does. There’s no “cash drag” on the fund.
The second piece is that the SEC has started to grant active ETFs the ability to use a semi-transparent structure when it comes to holdings disclosure. This eliminates many of the front-running concerns and size contracts when it comes to buying assets. Active ETF managers have more wiggle room with regards to what they can buy.
Passive & Active Can Work Together
The fact that active ETFs can eliminate some of these concerns is a real win for our portfolios. There are good stock pickers out there – and we can finally take advantage of them. There is research that shows that active managers in small, concentrated stock portfolios or sector-focused funds can – and do – outperform the market. Moreover, in the world of fixed income, credit analysis and security selection models can significantly beat the broader bond indices.
With low-cost active ETFs, there’s no reason we can’t take advantage of this opportunity.
How to do it? A core and satellite portfolio could make a ton of sense. Here, investors can use passive ETFs to make up the bulk of their holdings across a diversified basket of asset classes. This could be as easy as owning the Vanguard Total Stock Market ETF (VTI), Vanguard Total International Stock ETF (VXUS) and Vanguard Total Bond Market ETF (BND). You end up with a wide swath of stock and bond ownership.
The next piece is where active ETFs could come in. Once you have a low-cost core portfolio in place, you can start exploring other sectors, asset classes and styles. Say you want a little more growth in your portfolio, an ETF like the ARK Innovation ETF (ARKK) could be a good fit. Or you’re looking for different income sources, the SPDR Blackstone Senior Loan ETF (SRLN) or previously mentioned TDVG might be for you.
The point is, you can use both active and passive ETFs to achieve your goals. With active ETFs featuring many of the benefits of passive funds, the hurdles to making active management work are now diminished, or downright gone in most cases. Pairing both active and passive funds together should lead to better outcomes for all.
The Bottom Line
In the modern era, the passive vs. active debate is over. With costs being low for both forms of management in ETFs, the winner is with the investors. Using both active and passive ETFs in a core-satellite portfolio makes a ton of sense these days.
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