Your ETF is Not as Passive as You Think

When it comes to ETFs, a few stereotypes abound. Passive, low cost, flexible, broad exposure. While there’s some truth rooted in the stereotypes – some ETFs are index-trackers and have lower fees after all – investors should be wary of leaning too closely on these in their approach to ETFs. 

Depending on the way an ETF is managed, it could be highly active or have higher costs or be concentrated in specific stocks.  

Generally, when you select an ETF, you should be aware upfront of the style, whether it is active or passive. Even selecting a passive option may make you a more active market player than you realise. 

The different ETF structures 

ETFs started life as index-trackers, which is where their reputation for being passive comes from. 

In general, the word passive means to just sit quietly without taking part in broader activity. Investors should take care not to mix this definition up with the definition of passive in ETF investing – indexes move and this requires active buying and selling. They don’t sit still regardless of what is happening more broadly. 

Over time, ETFs have evolved beyond broad-based index tracking to include more customised forms, known as smart-beta, or active management. 

An easy way to differentiate between each type is if it aims to match a well-known large market index that you would hear regularly discussed on financial news, it’s passive. If it tracks an index that you wouldn’t hear commonly referred to in the news or a specific niche theme or style, it’s more likely to be smart-beta. If it is aiming to outperform the market with people making decisions about what to invest in, then it is an active fund. 

An overview is shown in the table below:

While investors are quick to appreciate what an active strategy is, investors can often assume that using broad and customised index-trackers are a completely passive approach and that you can simply ‘set and forget’. It’s not as passive as you think, and you should never set and forget an investment. 

Taking a broad-based approach can mean more active participation than you intend 

Typically, broad-based indices are weighted by market capitalisation – your money can be skewed towards the biggest companies on the index and you are ‘buying winners and selling losers’ as part of matching that index.  

You are effectively taking an active view that the market will continue to rise and investing as such, aka a momentum strategy. Taking such an approach can open you to a range of market risks. Unless you choose to manage these in other parts of your portfolio it can also have tax implications based on the turnover. 

Your investment is only passive to the extent that it is matching the index – but the index is an active and moving financial market measure. 

Many investors who use passive strategies advocate for taking an active approach to how you allocate to these, adjusting allocations to reflect market conditions and your goals and needs. Using a broad-based exposure can be an effective strategy, if you take an active view to how you are using it. 

Smart-beta indexes have an active element 

Smart-beta ETFs can often be broadly grouped with their more vanilla counterparts. The indices do have an active element to them in the form of the choice of filters, styles or alternative index weighting. It’s ‘passive’ with an edge. 

Consider an ETF that is designed to invest in high yielding equities.  

While it might track a specific index for this, the index itself has had active selection. It has built in algorithms to identify specific characteristics for yield, and exclude those investments that don’t meet those characteristics. It sets its index weightings based on certain criteria – whether it be a market weighting or an alternative – and then purchases the stocks on this basis. 

Equal-weighted ETFs might also seem somewhat passive – but it is taking an active approach to reduce risks from market concentration by weighting all stocks in an index equally rather than by market capitalisation. This can involve active buying and selling – a contrarian approach compared to the traditional market cap version given you are typically selling winners and buying the losers in the market to maintain that equal weighting. It can be higher turnover compared to market weighted versions – something to watch come tax time. 

Thematic ETFs veer closer to active management. 

The indices used in such investments are usually designed by an independent provider like Solactive or Indxx. They may even use experts to design the index methodology and make choices on classifying the investments used in it by investment committee. An example is the ROBO Global Robotics and Automation Index which uses industry experts in robotics on its committee to set the index.  

While the ETF is an index-tracker following the index, the index itself is actively designed and managed – it’s worth remembering when you select such an ETF that there are active decisions made in the underlying index.  

Passive index-tracking: Active market involvement 

Regardless of whether you use a ‘passive’ ETF or an active one, the investments don’t stand still and choosing a passive strategy still means an active market view.  

Your investments don’t remain static. 

Indices don’t sit still. 

Companies rise and fall based on financial data, so indices buy and sell those companies on that same basis. Passive ETFs match this. Smart-beta ETFs will add additional filters based on this. Active ETFs will take a step further with human overlay and analysis. 

Even with a passive strategy, your approach to your overall portfolio needs to be actively considered. Your ETF is not as passive as you think – but that’s not a bad thing either, as long as you take the time to understand what that means for your exposures and your overall strategy.  

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.