How to Compare Active and Passive ETFs
September 4th 2012 at 2:30pm by Tom Lydon
Actively managed exchange traded funds are back in the spotlight as many providers have launched them or plan to do so soon. Investors are told they will benefit from the lower costs, intraday trading and a chance to beat related indices, but some debate this.
“While on average, active management underperforms passive management by their fees, this says nothing about the return distribution of active management. Let’s take a look at the performance of broadly diversified index funds in the U.S. large-blend category. Virtually by definition, their returns tend to cluster near the category average on an annual basis,” Michael Rawson wrote for Morningstar.
Actively managed ETFs can actually diverge from the targeted benchmark, making the chance of outperforming difficult. The performance of active management as a category must include those funds that did not survive the term of study because of analysts ignore them, the analysis suffers a bias, reports Rawson. [Active ETF Sector is Gaining Traction]
Therefore, several studies can be performed with different focuses. First, we can analyze performance of only the surviving funds, knowing there is a bias. Second, we can asset weight the returns, which tends to diminish the effects of funds that close since these funds are typically small. Or we can substitute index fund performance for the periods after an actively managed fund closes.
Analysts also include the degree of risk aversion and the larger spread of outcomes that an actively managed fund may endure. These adjustments are actually penalties for risk regarding active management. [Active ETFs:Next Big Thing for Fund Managers?]
For long-term investing, however, the ability to trade intraday is not that valuable, Stephan Horan, head of the CFA Institute said. “Some folks, for example Jack Bogle, argue that simply the temptation to trade during the day is negative attribute of ETFs,” Horan said. “Others argue that the added flexibility cannot make investors worse off. It boils down to how important one believes the behavior biases are.” [ETF Spotlight: Actively Managed Funds]
Overall, it is hard to beat the performance of passive ETF investing against active management with these funds, over the long term. The comparisons of both categories are complicated and vary greatly.
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.