It's a common misconception among ASX investors that all exchange-traded funds (ETFs) are index funds. When the ETF first came to the ASX a few decades ago, this was pretty much true. But these days, it most certainly is not. Sure, there are still a plethora of index funds out there. Indeed, the most popular ASX ETFs among investors remain index funds for the most part. But the popularity of active ETFs is also on the rise and investors need to make sure they know the difference.
Tha's because many of the features that attract investors to index funds are not present in many active ETFs. Active ETFs tend to have significantly higher management fees. They also tend to be far less diversified than traditional index funds.
Active funds are NOT index funds
The primary difference between an active ETF and an index fund is how they invest. An index fund blindly mirrors an index. Thus, it is compelled to invest in whatever its parent index dictates. Most indexes are simple structures that choose their shares based purely on size. For example, the S&P/ASX 200 Index (ASX: XJO) holds the 200 largest companies on the ASX, ranked by market capitalisation. Thus, the larger companies have a higher weighting in the index than the smaller ones.
Active ETFs on the other hand can be thought of as a rough equivalent to a managed fund. They will typically have a fund manager and a team of analysts that actively choose which shares to include. The difference between a managed fund and an active ETF is simply how the shares, or units, can be bought or sold. A managed fund is typically unlisted, which means investors have to trade units with the fund directly. An active exchange-traded fund allows its units to be traded on the share market instead.
So are active ETFs even worth investing in?
When is an active ETF a good choice?
Chris Meyer, of Pinnacle Investment Management, recently shared some thoughts on this matter for Livewire. Here's some of what he had to say:
Active ETFs don't have the same low-cost benefits as passive ETFs, but there are times when paying an active manager to add some human common sense amidst the noise of choppy markets is valuable.
The real enduring benefit of the ETF vehicle (active and passive) to investors, however, is their ease of use. Simply buy and sell them like a share by punching in the ticker into your broking account.
Meyer also argues that the active structure more or less retains the benefits of a managed fund (the "human common sense", for example), without some of the drawbacks. Those would include the illiquid nature of trading unlisted units, as well as pricing delays that this process inevitably carries with it.
Another benefit, especially relevant to younger investors, is the absence of minimum investment thresholds. It's not uncommon for a managed fund to have a minimum investment of $20,000 or greater. That obviously puts it out of reach for many investors. But an active ETF's minimum is the same as buying any other share on the market.
So there are still fundamental differences between active ETFs and index fund ETFs. But Meyer argues that if an investor wants to choose between an active ETF and a managed fund, an active fund could be a better choice for many investors.
