Choosing between actively managed and passively managed ETFs can be a daunting task. So, this guide aims to demystify the key differences, benefits and potential drawbacks of each. Discover how to align your investment strategy with your financial goals and risk tolerance, ensuring a confident and informed decision.

ETFs explained

Before we dive into the ins and outs of actively and passively managed ETFs, here's a recap on what ETFs actually are.

An exchange-traded fund (ETF) is a versatile investment vehicle traded on stock exchanges, much like individual shares. ETFs consist of a diversified portfolio of assets , including shares, bonds, commodities or a blend of various investments. They offer a convenient way to access a wide range of markets and sectors in a single transaction.

ETFs operate by pooling money from numerous investors to buy a collection of securities that mirror a specific index, sector or asset class. This structure allows ETFs to replicate the performance of the underlying assets, providing broad market exposure. Unlike mutual funds , which are priced once at the end of each trading day, ETFs can be bought and sold throughout the trading day at market prices. This generally makes them more flexible and liquid.

What is an actively managed ETF?

Actively managed ETFs rely on professional fund managers to make strategic decisions about asset allocation. Unlike their passively managed counterparts, which simply track an index, actively managed ETFs aim to outperform a specific benchmark through careful selection and timing of investments.

Management style

The hallmark of actively managed ETFs is the expertise of their fund managers. These professionals continuously analyse market trends, economic conditions and company performance to decide which securities to hold, buy or sell. Their objective is to beat the benchmark index by leveraging market inefficiencies and emerging opportunities.

Potential benefits

Actively managed ETFs offer several possible benefits:

• Potential for higher returns: Due to the active oversight and strategic decisions made by fund managers, there is the potential for higher returns compared to passively managed funds
• Flexibility: These ETFs can quickly adapt to changing market conditions and economic shifts, allowing them to capitalise on new opportunities or avoid downturns more effectively

Possible drawbacks

Despite their advantages, actively managed ETFs also have some potential downsides:

• Higher expense ratios: The expertise of professional fund managers comes at a cost, leading to higher expense ratios compared to passively managed ETFs
• Risk of underperformance: If the fund manager’s strategy doesn’t succeed, the ETF could underperform its benchmark, introducing a level of uncertainty for investors

Actively managed ETF examples

• Magellan Global Equities Fund Currency Hedged (Managed Fund) (MHG) : An Australian ETF that invests in a diversified portfolio of global shares, targeting attractive medium to long-term returns through strategic asset selection
• ARK Innovation ETF (ARKK) : A US-based ETF known for its focus on disruptive innovation and technology sectors, aiming to capture growth in cutting-edge industries

What are passively managed ETFs?

Passively managed ETFs, also known as index funds, are investment funds designed to replicate the performance of a specific index, such as the S&P 500 or ASX 200. These ETFs aim to achieve this by holding the same assets in the same proportions as the index they track. The primary goal of passively managed ETFs is to mirror the performance of the underlying index as closely as possible, providing investors with broad market exposure.

Management style

The management style of passively managed ETFs is relatively straightforward. Instead of actively selecting and trading securities, these ETFs simply maintain a portfolio that matches the index.

Benefits of passively managed ETFs

There are several potential benefits to passively managed ETFs:

• Lower expense ratios: These ETFs require less active management, generally resulting in lower costs for investors. Investors can benefit from the cost savings, as lower fees can contribute to higher net returns over time
• Broad market exposure: Historically, many passive ETFs have offered a more stable performance (compared to more active investments) to their extensive market reach over the long term

Drawbacks to consider

Passively managed ETFs also have their possible drawbacks:

• Limited responsiveness: Because they’re designed to track an index, these ETFs lack the flexibility to react quickly to market changes or economic shifts
• Potential for lower returns: In highly volatile or bear markets, passively managed ETFs may see lower returns, as they cannot adjust their holdings to mitigate losses

Examples of passively managed ETFs

• SPDR S&P/ASX 200 Fund (STW) : In Australia, this ETF tracks the ASX 200 index, giving investors access to the 200 largest companies on the Australian Securities Exchange
• Vanguard S&P 500 ETF (VOO) : This popular US ETF tracks the S&P 500 index, providing investors with exposure to the top 500 companies in the US market

Key considerations for choosing between active and passive ETFs

When you’re tossing up between the two, there are a few things to think about. By carefully considering these factors, you can make an informed decision that aligns with your financial goals and risk tolerance .

Investment goals

Your investment goals are pivotal in choosing between active and passive ETFs.

For those eyeing long-term growth, passive ETFs have historically offered steadier returns and lower costs by tracking market indexes.

If you're chasing short-term gains or seeking to outpace the market, actively managed ETFs might catch your interest with their dynamic asset allocation strategies.

Risk tolerance

Risk tolerance is a key factor in your ETF strategy.

Active ETFs can potentially deliver higher returns but come with increased risk due to the fund managers' decisions. If you're comfortable with higher risk, active ETFs might be a good fit.

Conversely, passive ETFs, known for their broad market exposure and lower volatility, are popular among risk-averse investors looking for stability.

Costs and fees

Cost structures differ notably between active and passive ETFs.

Active ETFs generally have higher expense ratios due to management fees, which can impact overall returns.

Passive ETFs tend to be more economical, especially for long-term investors focused on minimising expenses.

Performance expectations

Historically, passive ETFs have provided consistent returns by mirroring market indexes, meaning they have a greater potential for stability.

Active ETFs, while having the potential to outperform benchmarks, also carry the risk of underperformance if the managers' strategies falter. Understanding these trends helps set realistic performance expectations.

Market conditions

Market conditions can sway your choice.

In stable or bullish markets, passive ETFs often excel by capturing widespread growth.

However, in volatile or uncertain times, active ETFs might shine as managers can pivot strategies to navigate the changing landscape effectively.

It's worth noting, though, that market conditions are entirely beyond an investor's control, and can change overnight.

So, which one should you go for?

To recap, actively managed ETFs offer the possibility of higher returns through strategic asset management. Passively managed ETFs provide lower costs and the potential for steady, long-term growth. And, as with all investments, both carry risk.

Choosing the right ETF depends on your financial situation, investing goals and risk tolerance. By understanding these factors, you can make a well-informed decision that aligns with your unique needs and helps you achieve your financial objectives.

Always consider the trade-offs between potential returns and associated risks when deciding between active and passive management strategies . And never hesitate to consult a financial adviser when you’re determining which path to take.

Happy ETF investing!