Active vs Passive ETF

Active ETFs try to beat the underlying benchmark indices with the help of the fund manager’s experience and investment strategy. On the other hand, passive ETFs simply try to mimic a particular index benchmark by employing a buy-and-hold approach.

Exchange Traded Funds (ETFs) started their journey in India in the year 2002 when the first ETF was launched on NIFTY 50 index. As of 2024, there are 200+ ETFs listed on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). ETFs represent a collection of securities that can be traded on the stock exchange similar to individual stocks. Investing in ETFs is different from investing in mutual funds as ETFs have lower expense ratios and incur a lower level of risk.

Mutual Fund Schemes NAVs are reported at the end of day, whereas ETFs can be sold and bought throughout the day. A Demat account is required for ETF investing but not for mutual fund investing. Investing in active vs passive ETF has been a long-standing debate amongst investors. In this article, let us gain insights on active and passive ETFs, key differences, advantages and limitations of both ETF types, associated risks, and expected performance.

Active ETF investing

1. Trading a passively managed ETF

There are investors and there are traders and never the twain shall meet. ETFs track the underlying indices they represent and generally achieve the expected returns. An investor realises the gains after holding an investment for a long time, whereas a trader will not be satisfied with the returns an investor is generating. Consequently, a trader will seek more returns and try to actively manage the passive ETFs in their portfolio. They will simply trade an ETF like a stock and sell the ETF units once the index goes in an upward trajectory.

2. Actively managed ETFs

Whereas trading a passively managed ETF requires the time and experience of an investor, actively managed ETFs include a fund manager or a larger management team. The team behind the actively managed ETF analyses trends, pinpoints investment opportunities, and finally decides the portfolio allocation strategy for the ETF. Actively managed ETFs provide an opportunity of generating returns that are above-average to investors and traders who are not content with returns based on the index. The actively managed ETF vs passive ETF strategy ultimately boils down to - whether you want index-linked returns or do you want index-beating returns?

3. Transparency and arbitrage

As ETFs trade on the stock exchange, there could be possibilities of dispersion in prices between the price of the ETF unit and the price of the stocks the ETF holds in its portfolio. And, this price disparity creates arbitrage opportunities. Whenever the price of one unit of an ETF trades at a discount from the price of the stocks it holds, investors buy ETF units and then cash them for in-kind distribution of stocks.

Conversely, when the price of an ETF unit is at a premium, investors usually sell some of their ETF positions and buy shares in the open market. For an index ETF, the price of an ETF unit is nearly close to the value of shares it holds. Therefore, this disclosure serves the interests of all parties for a passive ETF in the US.

4. The challenge of disclosing holdings

For an actively managed ETF, the fund manager’s objective is to beat the market benchmark index. If the actively managed ETF frequently disclosed its holdings, there would be no incentive for investors to invest in them because of little to no arbitrage. In that case, the purpose of an actively managed ETF does not exist since the fund manager’s investment style and strategy become known to everyone. Anyone having a Demat account can then buy and sell stocks in the same manner as an actively managed ETF and experience similar returns without having to pay fund management fees in the form of expense ratio.

5. SEC allows non-disclosure

The situation in the US and India are quite opposite in terms of regulatory requirement of portfolio holdings. While the Securities and Exchange Commission (SEC) does not make it mandatory for fund houses to declare the holdings of an actively managed ETF daily, the majority of the ETFs in India are required to disclose their holdings on a daily basis. This points to the fact that in the US, actively managed ETFs might be popular due to less stringent disclosure requirements. Whereas in India, ETFs are passively managed ones and there are no actively managed ETFs. Actively managed ETFs in India are referred to as ‘Index funds’.

Passive ETF investing

Passive ETF investing was the original form of ETF investing that was conceived as a way to generate index-linked returns for investors by tracking market indices. Basically, passive ETF investing seeks to replicate the returns generated by an index over a period of time without any active involvement of the investor. They do not involve any active involvement of the fund management team in deciding the portfolio allocation or trading strategy other than those taking place in the index. In India, some passive ETFs track several indices such as the NIFTY 50 index, NIFTY PSU Bank index, NIFTY Midcap 100, and others.

Intraday trading

While ETFs may seem to be similar to mutual funds as both hold a basket of underlying stocks, ETF units can be traded on the index like a stock that presents intraday trading opportunities to traders. Traders and investors can buy or sell ETFs throughout the day based on their research and analysis. Since ETFs are traded on the exchange, they offer more freedom to investors compared to mutual funds. However, the regular trading of ETFs also incur significant costs of transaction for investors. This sort of active ETF management can reduce return on investment and highlights the primary difference in strategy for active ETF vs passive ETF management.

Key Takeaways

• Exchange Traded Funds (ETFs) have been an attractive avenue for investments since they were introduced in India in 2002

• ETFs offer investors a more affordable way of generating returns by getting exposed to multiple asset classes, stocks, sectors, and markets.

• The passive ETFs employ a strategy called buy-and-hold for tracking benchmark-linked returns

• Active ETFs depend on the fund management team’s analysis and strategy of portfolio allocation to beat the benchmark.

• Passive ETFs generally have lower expense ratios than active ETFs, however, they can only provide index-linked returns and do not offer any opportunity to beat the index.

Differences between active and passive ETFs

Characteristics	Active ETFs	Passive ETFs
Suitability	Suitable for investors with a more aggressive risk profile	Suitable for investors with a moderate to low risk profile
Investment horizon	Generally, active ETF units are traded like stocks throughout the day.	Passive ETFs hold the underlying stocks for a long time without churning
Returns	The returns beat the benchmark index returns	The returns replicate the benchmark index returns
Cost	They are usually costlier than passive ETFs as they incur higher fund management and transaction costs	They are less costly than active ETFs because there is no active fund management involved
Portfolio	Concentrated portfolio	Diversified portfolio
Risk	Incur additional risk in the quest to generate additional returns	Incur lesser risk that that of active ETFs

Deciding between active vs passive ETF for new and experienced investors boils down to how much risk are they willing to take. The price movements for an active ETF are keenly monitored and the buying-selling cycle is timed for extracting maximum returns. On the opposite end of the spectrum are passive ETFs that are designed to simply track the benchmark and generate similar returns. Due to a highly diversified portfolio, volatility in some of the stocks is absorbed by the stable stocks that makes passive ETF investing less risky.

Pros and cons of actively managed ETF

An actively managed ETF has the following advantages:

Since there is a fund management team behind an actively managed ETF, they are able to capitalise on market opportunities and generate more returns on the short-term

Active ETFs generate higher returns for an investor compared to a mutual fund or a passively managed ETF which is commensurate with the additional risk taken.

Though active ETFs are traded like stocks on the exchange, they tend to be less volatile than individual stocks, and therefore, are a less risky alternative to stock trading.

However, there are some drawbacks associated with an active ETF as mentioned below:

• Active ETFs have a higher cost of investment due fund management costs and transaction costs. This finally results in a higher overall cost for the investor that decreases his overall returns.

• For additional returns generated above the benchmark, active ETFs have to incur additional risk. Thus, they entail a higher level of risk for the investors compared to passive ETFs.

• Actively managed ETFs cannot be highly diversified and they tend to have a more concentrated portfolio than passively managed ETFs. This results in less stable earnings than passive ETFs.

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• SIP Vs mutual fund

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• Types of SIP

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• What are the charges involved in a SIP

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Pros and cons of passively managed ETF

Passively managed ETFs stand for ‘long-term, stable returns’ and provide the following benefits:

• The returns are predictable due to a consistent investment strategy. This is usually beneficial for investors who are seeking stable returns without incurring any additional risk.

• A single unit of a passively managed ETF represents a high level of diversification as a unit of an ETF is created in proportion to the weight of the constituents of the underlying index.

• Retail investors get to own some portion of a highly valuable stock, which individually might be out of reach for them. This makes passively managed ETF a highly affordable option.

Even though they seem attractive, passively managed ETFs are not without the following limitations:

• They offer no scope of beating the benchmark returns because they do not incur any additional risk.

• Traders who are seeking quick returns through intraday trading will not view passively managed ETFs as aligned to their financial goals.

• Owning some portion of a valuable stock is not the same as owning a complete unit(s). Fractional holdings will hurt the original returns generated by the stock.

Performance expectations – Active ETFs vs passive ETFs

The expectation for active vs passive ETF are different as described below:

1. Active ETFs

A fundamental expectation of investors who invest in active ETFs is that the fund manager knows the best way to generate additional returns over and above the index, also referred to as the ‘alpha’. Belief in the fund manager’s investing style is a prerequisite for actively managed ETFs. Fund managers research individual stocks, market, and sectors, and decide the portfolio allocation. Thus, they have more flexibility.

2. Passive ETFs

The primary objective of a passive ETF is to mimic the performance of an index. It results in the returns for a passive ETF being similar to the index it is tracking. Since the portfolio is diversified, investors are exposed to multiple asset classes, markets, and industries. How closely a passively managed ETF has managed to mirror the benchmark is measured by tracking error. A lower tracking error corresponds to a higher degree of replicability.

What types of indexes do passive ETFs typically track?

• Passive ETFs in India typically track a variety of indices spread across several asset classes:

• Equity Indices: NIFTY 50, BSE MIDCAP Select, NIFTY IT, NIFTY200 Momentum 30, Midcap 100, NIFTY PSU Bank, NIFTY Smallcap 250, Nifty Infra, Nifty MNC, and others

• Fixed-income indices: CPSE Bond Plus, NIFTY Bharat Bond, NIFTY AAA Plus Bond, Government securities, etc.

• Commodities: Gold Index and Silver Index

Risks associated with investing in passive ETFs

Passive ETFs have some risks associated with them. An index is sensitive to market volatility and since a passive ETF mirrors the performance of an index, the ETF is subjected to market dynamics as well. A bear market affects the returns of passive ETFs. Next, if the tracking error for a passive ETF is on the higher side, the ETF may generate lower returns compared to the benchmark index returns. Moreover, since ETFs do not have high trading volumes, liquidity issues may arise that can make selling ETF units difficult.

Drawbacks of active ETFs

Active ETFs suffer from various drawbacks such as higher cost and reliance on the fund manager’s style. Since an active ETF involves a fund management team and frequent churning of stocks to generate alpha, they incur higher fund management costs and transaction costs compared to passive ETFs. Moreover, the active ETF investing strategy is dependent on the fund manager’s style and experience. These factors do not guarantee benchmark-beating returns. In fact, some active ETFs may generate lesser returns compared to passive ETFs that are free from the bias of a fund manager. A concentrated portfolio also makes active ETFs susceptible to concentration risk.

Summary

The eternal debate of investing in active ETF vs passive ETF boils down to the investor’s risk profile and financial goals. While both have pros and cons, it is generally seen that active ETFs outperform passive ETFs in the short-run while the reverse is true in the long-run. In any case, ETFs are a good opportunity for investors to get some exposure to equity markets before investing in individual stocks.

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