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September 1st, 2011 by

Active ETFs: Start Paying Attention

There is a lot of talk about Active ETFs. Do I care? Should I care? Is it good for me? Most of the investment community is slowly and finally getting to know and appreciate your basic (at it turns out to be) ETF, when the market is already moving to the next big thing.

If you look at the current set of about a thousand ETFs, you will quickly see that their sole and only purpose is to efficiently track an index, and they usually do so quite well, with low tracking error and moderate cost. What does it do for me, well it allows me to use them in a multitude of ways such as: provide wholesale exposure to certain sectors or countries, diversify portfolio, provide tax benefits, temporary park money.

Now, after several years, that we know what ETFs are all about, we ask ourselves that eternal cell phone question, how did we do without the cell phone before, and the same with ETFs, we actually ask ourselves the same question, how did we do without them.

As anything else, things get more sophisticated and more complicated with time and the same goes for ETFs. So just as we are getting more comfortable with “regular” or passive index replicating ETFs, those pesky innovators are throwing at us something new and different that will now require more of my attention.

I suggest “start paying attention”. By all means the active ETF space is moving fast, albeit from a low base, but it is moving fast. The simple and most primal reason it is moving fast and will pick up speed exponentially, is that as great as passive ETFs are, we all want our alpha, we need it and we need it all the time. Unless you do active management of your portfolio, as in one example that I suggested in my previous article such as active sector rotation, you are bound to do as well as the index. Not that it is necessarily bad, just look at most active managers who consistently underperform their benchmark. But I need my outperformance, it is my drug.

I want to emphasize the word outperformance, this is critical. Most people use the word performance and it is a misleading because unless you have something to compare your performance you really have no idea how well or poorly you are doing. If you recall your basic accounting or finance class and the ratio analysis: a basic ratio, such as quick ratio, price to earnings ratio and the rest are absolutely meaningless by themselves, they only acquire meaning and hence value, when they are compared to something.

So you need that outperformance and you will not get it with a passive, i.e. index, fund. It is here were active ETFs become very useful and in fact indispensible.  What they provide are the same or almost the same benefits, transparency, diversification, tax, as regular ETFs, but their premise is to outperform a benchmark and give you that alpha that you crave.

Clearly, actively managed ETFs are great if they perform how they are intended to do, meaning that you are now at the mercy and hopefully skills of a portfolio manager who actually actively manages the portfolio within that active ETF. Now is the time to do your homework and dig in to assess which active ETF manager suits your fancy and fulfills your need within your portfolio’s asset allocation.

A question is begging to be asked, aren’t the active ETF managers similar to mutual fund managers who typically underperform their respective benchmark? Great question and the right one for the times. There are very distinct differences between active ETF managers and mutual fund managers. The inherent differences come from the nature of ETFs. ETFs have typically lower management fees, while mutual funds have higher ones, ETFs are transparent, while mutual funds are not, ETFs have better tax efficiency than mutual funds. The major reason mutual fund managers under form their benchmarks are fees, so naturally the lower the fees the better the potential outperformance.

So we come full circle by not only loving our ETFs even more, but also embracing and relishing that extra alpha.

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