The difference between passive and active ETF investing
Novice investors just getting started with exchange-traded funds often ask whether they’d get more bang for their buck with a couple of “smart beta” funds added to the mix. But I generally advise thinking twice before jumping in to these specialized funds. Here’s why.
Most beginning investors test the waters with either a balanced mutual fund or with ETFs that track large, well-established stock and bond indices.
These include, for example, the S&P/TSX Composite Index for Canadian stocks, the S&P 500 Composite Index for U.S. stocks, the MSCI EAFE Index (that is, the Europe, Australasia and Far East Index) for stocks of developed countries outside North America.
For Canadian bonds, an ETF that tracks a broad index of both government and corporate issues would be one to include in a balanced portfolio. The FTSE/TMX Universe Bond Index is the broadest Canadian fixed-income index. A wide choice of investable global bond indices are also available, from index-producers such as FTSE Russell, Dow Jones, Standard & Poor’s, and MSCI (Morgan Stanley Capital International).
A balanced portfolio of ETFs could be apportioned, for example, 60% equities (divided into, say, 40% Canadian and 60% non-Canada international), and 40% Canadian bonds. You could accomplish this with the purchase of only three broad passive-index ETFs.
So-called “smart beta” ETFs are a relatively recent innovation in the ETF industry. So perhaps a little defining of terms is in order.
A broad, passive, index-tracking ETF goes back to the roots of exchange-trade funds, which were developed in the last 20 years of the twentieth century. It is simply a fund that passively tracks the performance of a large, capitalization-weighted index, such as the S&P/TSX Composite Index or the S&P 500 Composite Index.
The individual components of these indices are weighted according to the size of their market capitalization (the price of a company’s stock multiplied by the number of shares outstanding). Consequently, the larger a company’s market cap, the greater its influence in the performance of the index.
For example, tech firm Apple Inc. (NASDAQ: AAPL) recently topped US$800 billion in market capitalization, becoming the world’s most valuable company. It constitutes about 4% weighting in the S&P 500. In Canada, the S&P/TSX Composite Index, also capitalization weighted, is dominated by Canada’s big banks and insurance companies, as well as larger resource companies in the energy sector.
As the ETF market developed and matured, fund companies began offering ETFs that aimed to deliver performance better than what can be obtained simply by buying and holding a capitalization-weighted index. These came to be known as “smart beta” or “factor based” ETFs.
Smart beta funds basically incorporate, or “overlay,” various types of active strategies on an index in an effort to enhance returns. These strategies could include fundamental screens (such as various financial ratios or dividend growth), low volatility metrics (to reduce risk), high beta (for aggressive growth), commodities, options, and multi-asset tracking. Because they tend to use more sophisticated strategies, they tend to be used more by portfolio managers to augment investor portfolios in one way or another.
Most smart beta ETFs have higher MERs than standard passive index-tracking ETFs, and have come under criticism as simply a way for ETF issuers to collect higher fees.
Moreover, smart beta ETFs are still quite new to the market, and while they have been back-tested with historical data, they do not have a long-term performance history through a real-world market cycle.
For novice investors building their first portfolio, then, I’d advise sticking with tried-and-true, index-tracking ETFs. They’ll give you broad exposure to the market, they have a long history of performance through various market cycles, they have the lowest MERs, and they are highly liquid. Leave the smart-beta strategies for professional portfolio managers, or until you’re more comfortable with sophisticated strategies yourself.
© 2017 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice. Securities mentioned are not guaranteed and carry risk of loss.