ETF INVESTING: ACTIVE OR PASSIVE?

An exchange-traded fund (ETF) is a security tracking a basket of assets, a commodity, bonds, or indexes. Available in hundreds of varieties, ETFs offer all of the benefits seen in index mutual funds such as low turnover, broad diversification, and low cost, not to mention its significantly lower expense ratios.

There are at least two major ETF investment strategies (to be outlined in this article): active and passive.

Active Investing

This is regulated by a manager or team, they decide on the underlying portfolio allocation or follow an active investment strategy. The fund has a benchmark index even though managers can change sector allocations, market-time trades, or deviate from the index. The managers aim to outmatch the market with their exceptional skills, specifically to surpass a certain benchmark.

Through intraday trading, investors can monitor the direction of the market and trade accordingly. They can also optimize short-term movements. For instance, if the S&P escalates when the markets open, active traders can secure profits right away. Some active trading strategies that can be employed include buying on margin, market timing, section rotation, and short selling.

However, several investors are not satisfied with its average returns amid its track record. Minority of actively-managed funds beat the market, and it is more expensive, resulting in higher fees and operating costs.

Passive Trading

Most mutual funds are passively managed. Essentially, ETFs are designed to provide a single security trailing an index. Also called indexing, it trades intraday, enabling investors to purchase and sell all of the securities in the entire market with a single trade. Hence, it provides the flexibility to get into or out of a position at any time throughout the day. It seeks to mirror the index’s performance the closest possible – not beat the index’s performance.

It offers convenience to investors who prefer to buy and hold. Unlike in active trading, managers or a group of managers do not decide on the securities to be sold and bought. But they follow the similar methodology of creating a portfolio as the index uses.

Managers invest in broad market sectors called asset classes or indexes. Passive investors are willing to accept whatever the return is since this trading relies on the underlying index. They also believe in the efficient market hypothesis (EMH), stipulating market prices are always fair and quickly reflective of information. Believers of this hypothesis denote outperforming the market consistently for the professional and small investor alike is not easy.

ETF investors often use active and passive management. Both are legitimate, so picking the best strategy will depend on your risk appetite and financial goals. Be careful with your choices though.