blueactiveetfindexPrinters and active index funds have something in common: the potential for longer-term hidden costs.

A printer may not be expensive to buy up front, but the necessary ink and toner refills can be quite steep. Consumers may get a great deal on a printer, yet hidden costs await in the ink.

The same is true for active index ETFs (exchange traded funds). Unlike passive or “market-cap-weighted” indexes, which rely on the market’s valuation of securities to determine weightings, an active index aims to systematically deviate from market-cap weighting, in pursuit of outperformance.

This is done through a defined process that frequently changes the weighting of each holding based on other information.

As a result, these ETFs tend to have higher turnover, concentration risk, and tax exposure, and drift away from market returns.

The higher expense ratios these active ETFs may charge can also be problematic, and do not equate to, nor guarantee higher returns.

According to a Morningstar study, expense ratios were touted as one of the most important determinants of a fund’s long-term performance relative to its peers.1

But, contrary to general assumptions, paying higher expense ratios does not guarantee higher returns in an investment portfolio.

A separate Morningstar report showed an inverse relationship between fees and performance. Analysis among U.S. equity fund ETFs in the lowest quintile of expense ratios produced the highest total returns, whereas those funds in the most expensive quintile of expense ratios produced the lowest returns.

A Vanguard study also found that high expense ratios are often an effective predictor of fund underperformance, yet even low-cost active funds still underperformed their benchmark about 70% of the time.2

Indexes Defined

Think of an index as a formula or equation. This formula tells you in which securities to invest, and in which specific weights and allocations.

Indexes have two main positive properties. They are:

  • Systematic; rules-based, not based on a manager’s preferences or gut-feelings; and,
  • Transparent; investors can replicate the index weights at any time.
Tracks Index Infrequent Trading/Changes
Active Mutual Fund No No
Active Index Fund (new) Yes No
Passive Index Fund Yes Yes

This doesn’t mean that all indexes are passive, however. Imagine if we created a daily top winners” index that invested in yesterday’s top five performing stocks, with weights determined by their relative returns.

While this approach is systematic and transparent, it’s certainly not a passive strategy. It has very few holdings, which will change daily, and the weights of the index will also change daily, producing significant turnover and concentration risk in any fund that attempted to track that index.

Benefits of Passive Indexes

Passive (market-cap-weighted) indexes have some unique characteristics that separate them from non-market-cap indexes.

Lower Turnover: Any change in the market cap of a single holding is automatically and immediately reflected in the index, without any work necessary on the part of a fund manager.

If the price of a stock increases by 10%, as a fund manager you don’t need to do anything; your holdings also went up by 10%, so you’re still tracking the index.

To be fair, all funds including market-cap funds must go through some turnover due to non-index factors, such as fund flows, dividend payments, and corporate actions like mergers and de-listings. But we believe it’s hard to beat market-cap funds for low-turnover due to the index weighting.

Active indexes that use some other factor to determine weightings may require more turnover, both when that other factor (for example, momentum) changes, rebalancing results in drifting away from a target.

Lower Tax: Because market-cap-weighted indexes generally require less trading, they tend to realize lower capital gains. And lower capital gains means lower taxes for the end investor.

Lower Internal Trading Costs: Much like there’s a cost associated with placing a trade, the same applies to a fund manager’s trade.

The fund has to pay both their own broker, as well as the bid-ask spread on transactions.

Funds following active indexes will have higher internal trading costs due to more frequent trading, commissions and spreads.

So while the difference between active and passive seems simple, it may be difficult to determine how passive an index fund’s strategy really is.

Know Your Index

A new breed of ETFs is similar in name only to passive ETFs, but instead exhibits the characteristics of a traditional actively managed portfolio—particularly in fees and turnover, and for less than certain higher returns.

Examples are inverse (or “short”), leveraged, and smart-beta ETFs. Smart-beta funds may only confuse rather than help most investors.

According to a Wall Street Journal report, smart beta funds’ stocks are weighted “by rules or ‘factors’ other than their market value, such as their dividends, value or low volatility.”

While proponents say that these funds can outpace a straight index over extended periods—say, a full market cycle or two, “don’t expect outperformance every year,” said the report.

In fact, according to ETF.com, “Actively managed ETFs by design are expected to deliver outperformance, but they often underperform their benchmarks.”

Investors should also be aware that smart-beta ETFs rely on the actions of fund managers who dictate the actual execution of the fund’s investment strategies.

Their promise of better performance may lead an investor to capitulate during a down market if the fund doesn’t deliver. According to the Wall Street Journal, “If you are anything less than a true buy-and-hold investor, your smart-beta bets could fall well short of short-term expectations.”

Despite passive indexing’s positive track record, many investors still want to beat the market, or simply have high return with low risk. Active index ETF’s appear to offer the chance to have it both ways—low cost, and potential for high performance—however the allure fades with active index investor returns.

Thus, investors who skip over index and expense ratio details may unwittingly subject themselves to higher fees and returns reminiscent of an actively managed fund.

1The Cost of Owning ETFs and Index Mutual Funds, pg. 2.

2The case for Vanguard active management: Solving the low-cost/top-talent paradox? Figure 1, pgs. 3-4, and according to Figure 1 the average over the last 25 years, the lowest cost decile fund beat its index about 30% of the time, so it lost about 70% of the time.

This article originally appeared on ETF.com.

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