'Active' ETFs could be fool's gold

Exchange-traded funds (ETFs) are proving popular around the world and with local investors. There are more than 230 ETFs listed on the Australian sharemarket.

These are the index-tracking ASX-listed funds where the return is the market that is tracked, less a management fee.

Those markets can be anything – Australian shares or sectors, overseas sharemarkets, commodity prices or currency exchange rates.

But there is a new type of "active" ETF that is very different to vanilla ETFs and investors who think they can be used in anything like the same way, need to think again.

For example, there is an ETF listed on the Australian sharemarket whose returns are inverse to the US sharemarket – if the US sharemarket rises, the value of the units in the ETF fall, and vice versa.

It uses futures to magnify not only the gains, but also the losses.

Investors like vanilla ETFs as the units in them are traded on the sharemarket just like shares in listed companies. The unit price reflects the performance of the index being tracked.

That's different to a listed investment company (LIC) in which the price of its shares can move away from the value of the assets held by the LIC, depending on how much demand for the LIC there is from shareholders.

And LICs are active managers; they buy and sell investments to try and beat the market in which they invest.

And, as with all active management, regardless of how they are structured – LICs, ETFs or unlisted managed funds – most fail to beat the market.

With index trackers, you'll never do better than the market, however, nor will you do any worse.

They can be a good way of getting diversification to a portfolio that is heavy with a small number of large Australian-listed companies.

Trying to pick winners is not easy – whether for an active fund manager or an active ETF.

Trying to pick winners is not easy – whether for an active fund manager or an active ETF.

They are particularly popular with those who have their own super funds – who are mainly investing in them to get further diversification into their portfolios.

Australia’s ETF industry finished the first half of the year at a new high of $39.2 billion in funds under management.

A report by BetaShares says industry growth for the half was $3.2 billon with the majority coming from inflows as opposed to asset appreciation, with $2.7 billion of new money flowing into the industry over the six months.

While most of the inflows is into passive ETFs, active ETFs are becoming more popular.

These could, say, track only the highest-dividend paying stocks listed on the Australian sharemarket.

Most of the return is still expected to come from the market, but the idea is to provide investors with a bit more income. That is all right as far as it goes.

It is the ETFs with the much more active strategies where particular caution is needed.

With vanilla ETFs the responsibility for the returns is with Mr Market and with the investor who chose to invest in the market.

The active ETF carries much greater responsibility for how the ETF performs than for their vanilla-ETF counterparts and investors in active ETFs will point the finger at the ETF provider if it goes wrong.

With active ETFs, the fee advantage over active managed funds is not nearly as great – the more active the ETF, the higher the fee.

For sure, ETFs are more convenient than investing in unlisted managed funds. But those tempted to invest in an active ETF need to ask themselves a question.

Given that most active fund managers fail to outperform, why should it be any different with active ETFs?

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