What is the fuss about Exchange Traded Funds (ETFs)?

In the past few years, the term exchange traded fund has been talked about at first as casual, yet later to lean into a heated debate. In this article, we will be looking at the reason the debate is taking place and our thoughts about it as an investment firm.

What is an Index of Shares?

To understand what exchange traded funds are, we first need to explain what an index of shares is. A share index is a way to measure a group of assets. An example would be the Financial Times Stock Exchange (FTSE) 100 or informally known as Footsie. This index specifically measures the 100 companies listed on the London Stock Exchange with the highest market capitalisation.

Now that we have clarified what an index is, an exchange traded fund is an investment vehicle created to follow a specific index of shares. The differentiating factor of an exchange traded fund (ETF) is that it is typically passively managed. The goal of an ETF is to perform similarly to the index it is tracking.

Passive vs. Active ETFs

Passive ETFs are passively managed ETFs, set up to follow a broad index of shares or a narrower industry or trend. Active ETFs are actively managed by portfolio managers who decide which securities (stocks, bonds, preferred shares) to include in the portfolio. Actively managed ETFs are usually more expensive than passively managed ETFs.

Types of actively managed Exchange Traded Funds include:

  • bond ETFs,
  • stock ETFs,
  • industry/sector ETFs,
  • commodity ETFs,
  • currency ETFs,
  • inverse ETFs, and
  • leveraged ETFs.

ETFs vs. Actively Managed Investment Portfolios

This creates a debate for active portfolio managers. The main concern for active managers is that there is no way to outperform the market index when using an ETF. Active portfolio managers’ research in the companies they plan to buy shares in will give them the competitive advantage to the market index.

ETF’s normally charge lower fees, which arguably can make up for the outperformance by actively managed portfolios. With the Covid pandemic, it was the time for active portfolio managers to shine. In one of our BizNews article written in April 2021, the following was found: “According to the latest Morningstar European Active/Passive Barometer, the early 2020 volatility that was caused by the coronavirus pandemic was the perfect opportunity for active fund managers to deliver alpha, turning around the last 10 years of underperforming their passive peers. Data from the report indicates that about half of all active European equity fund managers and one third of active European fixed income fund managers beat their passive peers in the first half of 2020. Actively managed equity funds typically hold more cash than their passive peers, who helped to soften the double-digit drawdowns that were seen in the first quarter of 2020. This partially explains why active equity fund managers outperformed active fixed income managers. Fixed income managers were also hurt by taking on more credit than their equity counterparts.”

Some investors do use ETFs as part of the portfolios they manage, since it is a clever way to get into a niche industry. We are past the point where it needs to be an either/or discussion for active or passively managed portfolios.

ETFs has grown in popularity and with that comes additional Exchange Traded Funds created, and much like the indices they track, not all ETFs are equal. ETFs differ in terms of the industries that they cover, the number of companies of shares they hold, the weightings of those companies. All these factors will determine the performance of the ETF.

Investment portfolios that include ETFs

No matter how you decide your invest portfolio and its asset allocation will look like, in both cases, it is important to do your research and know what you are buying, whether it is an ETF, your own selection of shares, or a mixture of both. Both investments offer a great way to access the market and start investing and having a combination of both ETFs and actively managed portfolios can be advantageous to one’s investment portfolio. For more information on ETF’s feel free to discuss the details with our wealth managers.

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