Active vs. Passive ETFs: What to Look For

Exchange-traded funds have long been associated with passive management – which means the funds attempt to replicate the returns of a benchmark, like the S&P 500, rather than beat the benchmark. But as the industry has matured, and fund companies attempt to differentiate from each other, more ETFs are adopting an active strategy. Their goal is to beat the benchmarks, minus fees.

“Not every investor is satisfied with a fund that simply wants to mirror the returns of an index,” said Joe Correnti, senior vice president of brokerage product at Scottrade. “There is a demand for actively managed ETFs.”

So what are the differences between active and passive exchange-traded funds?

  • How a passively managed fund works. The short explanation is that a passively managed fund attempts to match the performance of a particular index as closely as possible by purchasing all of the securities in that index or a representative sample. When ETFs were first formed, those indexes were typically relatively major ones such as the S&P 500. But some ETFs are now effectively creating their own indexes.
  • How an actively managed fund works. Actively managed fund managers have an investment objective, but they are attempting to beat the performance of an index, rather than track with it. Actively managed funds typically have larger research and management teams than passively managed funds.
  • Fees. ETFs assess a fee to offset the cost of operating and managing the fund. In general, actively managed funds will have higher fees than passively managed funds for a couple of reasons. First, actively managed funds tend to have higher trading costs, because they buy and sell securities more often. Second, actively managed funds have larger research and management teams than passive funds, which simply rely on indexes to determine their holdings.
  • Taxes. Because actively managed ETFs tend to do more trading, they also are more likely than passive funds to generate capital gains that shareholders have to report.
  • Risk. Passively managed funds closely match the risk of whatever index they’re attempting to track. Actively managed funds could be more or less risky than the indexes they’re attempting to beat, depending on the investment decisions they have to make.
  • Tracking errors. Passively managed funds have to guard against tracking error. Tracking error is a measure of the difference between the ETF’s returns and the index it’s attempting to track. Several factors can conspire to widen tracking error, but most come down to the complexities of buying the exact securities in the exact percentage of an index. Actively managed funds don’t try to replicate indexes, so they don’t have to worry about tracking error.

“When ETFs first came out, they were plain vanilla,” Correnti said. “And that’s OK. But for investors who are looking for something different, there are now plenty of choices. But like anything, if you’re on your own, you need to do your homework to figure out what works best with your investment plan.”

Question: Do you prefer actively or passively managed ETFs?

Next Steps: Scottrade clients can research ETFs by logging in and going to the Quotes & Research page. Not a client? You can find ETF research tools as well.  

The information and content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange Traded Fund (ETF) before investing. A prospectus contains this and other information about the fund and may be ordered through www.scottrade.com or through a Scottrade branch office.  The prospectus should be read carefully before investing.

Scottrade does not provide tax advice. The material provided in this article is for informational purposes only and Scottrade is not responsible for any errors or omissions. Please consult your tax or legal advisor(s) for questions concerning your personal tax or financial situation. 

*Boomer Expectations for Retirement 2015: Fifth Annual Update on the Retirement Preparedness of the Boomer Generation, by IRI.

**Solutions offered through Scottrade Investment Management involve additional fees.
Guidance Solutions from Scottrade Investment Management™ and Advisor Access from Scottrade Investment Management™ are investment advisory services offered by Scottrade Investment Management, a registered investment advisor. Brokerage products and services are offered through Scottrade, Inc., member FINRA / SIPC, while advisory services are provided by Scottrade Investment Management. Scottrade Investment Management and Scottrade, Inc. are both wholly owned subsidiaries of Scottrade Financial Services, Inc. This is not an offer or solicitation in any jurisdiction where we are not authorized to do business.

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