Markets

4 Key Factors To Consider Before Selecting An Active ETF

ETF investors have wholeheartedly embraced the transparency and low-cost of passively managed investment vehicles. Billions of dollars every year since the great financial crisis have left the obfuscated world of high-priced mutual funds and transitioned into index-based ETFs.

This rotation is almost entirely based on the foundation that you know exactly what you own, why you own it, and what the minimal expenses will be. There is a comfort and reliability that the fund will perform to an exacting standard with very little deviation from its benchmark.

Yet despite this seemingly unstoppable trend towards passive indexes, there are still going to be investors that consider the merits of active funds. Ones with managers they trust or strategies that are simply not available through a rules-based methodology. There are also those who seek the holy grail of outperforming the market or place a high value on the benefits of risk management.

If you find yourself among this group, it’s important to analyze each unique fund or strategy with an eye towards four important factors detailed below.

Portfolio Differentiation vs Index

The first stop in any analysis should be highlighting the strengths and weaknesses of an active portfolio versus a similar benchmark. Ask yourself these important questions:

  • How does this strategy differentiate itself?
  • How does it make ongoing changes versus a static index?
  • What are the potential benefits or risks to this active portfolio and do they align with my goals?

Answering these questions may help immediately pinpoint whether the fund is right for you. Active funds often take a more concentrated approach than a broader benchmark to try and outperform their peers. This may create varying risk dynamics that you should be aware of before you decide to invest.

They may also have broad interpretation of the managers discretionary authority to make changes. You should know how much cash they can raise or if unconventional investment classes may be used to manage risk or enhance returns.

Track Record & Manager Experience

Track record is always an important dynamic to consider as well. This will be best interpreted through real-world data if the ETF has been in existence for 3-5 years. If not, the manager may have similar strategies employed through an active mutual fund, hedge fund, or separate accounts that can be used as proxies.

You should compare the returns of the actively managed ETF to a similar index to see if their results meet your expectations. They may prove to be proficient in one type of market, but fail to outperform under other adverse circumstances. This analysis should help you decide if the fund is able to meet your goals or if perhaps an index is truly a better route.

Cost

Investment expenses are an important factor in total return. You can’t control future performance or market fluctuations, but you can know exactly what the costs are in your portfolio at any given time.

Actively managed ETFs generally have higher expenses relative to their index-based counterparts. There are some exceptions to this rule, but in common practice, the universe of passive ETFs is cheaper to own. The assumption is that active managers have higher embedded expenses in the pursuit of outperformance or to strategically manage risk. Sometimes the results are worth the money and sometimes they are not.

The important take-away is knowing what the expense ratio of an active ETF is and evaluating whether it’s a reasonable premium for the differentiated strategy.

Expectations

Setting sensible expectations is one of the most under-rated factors in the selection of any active strategy. You should know going in that active managers will face periods of outperformance and underperformance that are unpredictable at best. Those cycles also won’t necessarily correlate with past periods of success or failure. Market dynamics dictate that each successive boom and bust series will display its own challenges and opportunities.

My advice is to set realistic goals for your active ETF and continue to monitor it versus its benchmark on an ongoing basis. If it stays within an acceptable boundary or exceeds your expectations, then it is likely adding value to your investment efforts. Conversely, if the fund begins to persistently degrade versus its performance benchmark, then it may be time to move on and consider other opportunities.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

ETFs Investing