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Index or active ETF?

There can be no question about the popularity of ETFs based on methodologies other than standard capitalization weighting. But within this category there some big and important differences. One of the most significant is between funds that track smart beta – i.e. non-cap weighted indexes, and actively managed ETFs that dispense with the idea of tracking an index altogether.

Rather than seeking to replicate a benchmark’s performance, the manager of an active ETF seeks to add value with respect to the benchmark by making discretionary portfolio management decisions.

According to Deborah Fuhr, partner at research firm ETFGI, as at the end of August 2014, global assets invested in equity ETFs tracking cap-weighted indexes totalled $1.56 trillion, assets in smart beta index tracking equity ETFs totalled $267 billion, assets in ETFs tracking other types of equity index (such as environmental, social and corporate governance or ESG indexes) totalled $150 billion, and assets in actively managed equity ETFs totalled $26.7 billion.

Source: ETFGI, as at August 2014.

Two things stand out from Fuhr’s figures. First, ETFs based on traditional, cap-weighted indexes are still by far the most popular type of fund. Second, non-standard but index-based ETFs have attracted a lot more money than ETFs run by portfolio managers on a discretionary basis: smart beta equity ETFs alone have assets ten times greater than active ETFs.

One reason for this may be the higher costs associated with the generally higher turnover in actively managed ETFs. Any index that departs from the traditional methodology of weighting constituents by market capitalization generates higher levels of turnover. But turnover levels in an active ETF are quite likely to be higher still. This reflects the decision-making process of the individual portfolio manager, who needs to buy and sell stocks to try and generate the desired performance level.

For example, the average annual two-way turnover in the cap-weighted FTSE 100 index between end-2011 and June 2014 was around 6%, the average annual two-way turnover in the FTSE 100 Equally Weighted index (a simple form of smart beta index) over the same period was around 44%, but, according to a recent media report, the turnover of the average actively managed UK equity mutual fund is 65%.

Although active ETFs are attracting some interest (particularly from the managers of traditional mutual funds who would like to add the ETF structure to their fund ranges), the statistics suggest that, for the time being, when it comes down to a choice of index tracking or actively managed ETF, most investors strongly prefer the index tracking option.

 

 

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