Exchange traded funds (ETFs) can offer investors with a pair of options depending on their portfolio needs: passive or active. What exactly is the difference between the two?
There are a number of ETFs in the ever-growing market that offer a passive strategy. These ETFs are just that —passive, meaning they follow an index such as the S&P 500 as seen in the popular SPDR S&P 500 Trust ETF (SPY) .
They offer investors a set-it-and-forget-it strategy whereby their investment is subject to the performance of the particular index the ETF follows. This index can be composed of a variety of assets like stocks and bonds, giving investors exposure to a wide array of assets, depending on what they’re looking for.
Given that passive ETFs follow an index as opposed to hiring a portfolio manager to manage the holdings in the ETF, their costs tend to be lower. In times when inflation is high and investors are more cost-conscious, passive ETFs are an ideal option.
As mentioned, however, passive ETFs are subjected to the performance of the index they track. It’s like driving without a steering wheel — it offers strong performance when the index heads upward, and the opposite when it heads down.
For an added element of control, an investor might opt for an active strategy. That control goes to a portfolio manager, so essentially an active ETF is like adaptive cruise control — it adjusts the speed given traffic/market conditions while the driver/investor sits back and relaxes.
Active: Like a Mutual Fund, But More Flexible
Like their mutual fund counterparts, active ETFs can give investors more dynamic exposure to the markets. This means the ETF’s holdings can be adjusted to gain or reduce exposure to certain holdings given their performance.
This is done with the help of a portfolio manager who adjusts the ETF’s holdings based on the market conditions at the time. The manager can tailor the holdings in order to extract more gains by adding to a position or to mitigate risk when an asset is underperforming.
For example, in an ETF that tracks technology stocks, the portfolio manager can add more exposure to a certain stock that is exhibiting strong performance and sell a stock in one that’s showing weakness. This allows more flexibility without the investor actually having to monitor the portfolio constantly — it’s essentially the same set-it-and-forget-it strategy that a passive ETF implements, but adds an active strategy that’s built into the fund.
Unlike their mutual fund counterparts, however, active ETFs can also offer intra-day trading. This allows investors (likely short-term traders) to buy and sell active ETFs on a market exchange just like any ETF.
Active ETFs will generally cost more in terms of their expense ratios, but prices have come down in recent years, making them more competitive with passive ETFs. This is one of the reasons more investors are looking to active ETFs as of late.
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