Active versus passive management
This series is our attempt to educate our readers about leveraged ETFs. Before we touch upon leveraged ETFs, we’d like to help our readers understand the key differences between actively managed and passively managed ETFs, as leveraged ETFs fall in the first category.
Traditionally, ETFs have been designed to track indices and so were managed passively. However, in 2008, the Securities Exchange Commission (or SEC) allowed ETFs to operate as actively managed funds. Actively managed ETFs don’t track any particular index. Instead, they seek to enhance the returns through the frequent churning of their portfolio. They use different strategies, like market timing, dynamic sector allocation, short selling, and derivatives as well as leverage. While actively traded ETFs try to beat the market, a minority of them actually do. This conforms to Market Realist’s realist principles.
The actively managed ETF market is more favorable for fixed income (BND) ETFs in this category due to the heightened appetite for bond ETFs, the search for higher returns from yield movements, and fewer products of choices. The PIMCO Enhanced Short Maturity Strategy Fund (MINT) is the largest actively traded ETF to date, with assets of $3.9 billion. The fund invests in short-duration investment-grade debt securities.
Actively managed ETFs tend to have higher expense ratios due to the higher transaction costs associated with the frequent churning of their portfolios. Further, certain actively managed ETFs also use derivative products, which add to the transaction costs. This reflects in the fact that the most expensive ETFs listed in the above table are managed actively. The largest actively managed fund, the PIMCO Enhanced Short Maturity Strategy Fund (MINT) has expense an ratio of 0.35%, compared to the SPDR S&P 500’s (SPY) 0.09%. The SPDR S&P 500 (SPY) is a passively managed ETF that seeks to mirror the performance of the S&P500 index by investing in the S&P500’s constituents, like Apple (AAPL) and Exxon Mobil (XOM).
To learn about the difference between active ETFs and mutual funds, read on to the next part of this series.