What Is Passive Vs Active Investing? - InvestingChannel

What Is Passive Vs Active Investing?

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What Is Passive Vs Active Investing?

Sometimes the world can get too complicated for its own good. Too specialized. Too many niches. Too many options. A Thanksgiving smorgasbord of choice that can make you overeat to the point of losing track of what’s entering your mouth. 

After something we read in the Financial Times over the weekend, The Juice thought it made sense to go back to basics on ETFs and general long-term investing. 

The FT notes that there has been a shift in the ETF landscape. 

Looking at US ETF inflows (that is how much money comes into the products) since 2017, investors split their money up like this:

  • Low-cost passive ETFs: 62% of all ETF inflows
  • All other passive ETFs: 26%
  • Active ETFs: 12%

However, in 2022, active ETFs officially took the world by storm:

  • Low-cost passive ETFs: 61%
  • All other passive ETFs: 11%
  • Active ETFs: 28%

These numbers are actually pretty crazy. Let’s make sense of them step-by-step. 

Earlier this year, we explained the difference between the two types of ETFs:

SCHD and YVM follow a passive investment approach. That is both ETFs aim to replicate the performance of a specific index. In SCHD’s case, it’s the Dow Jones U.S. Dividend 100 Index. For VYM, it’s the FTSE High Dividend Yield Index.

SCHD being the Schwab US Dividend Equity ETF (SCHD) and YVM the Vanguard High Dividend Yield ETF (VYM). SCHD and VYM both have expense ratios of 0.06%. When you see “cost” associated with an ETF, we’re mainly talking about expense ratio, which is simply the yearly management cost a fund incurs. At an expense ratio of 0.06%, you’ll pay $6 in fees per $10,000 invested.

For some perspective, the average expense ratio across all Vanguard ETFs is 0.05%, while the industry average is 0.25%. According to Vanguard, funds similar to VYM have an average expense ratio of 0.90%. 

The FT article never objectively defined low-cost, however, given the number of more-than-formidable choices in the 0.06% area, The Juice will go ahead and say you need to make a strong case for paying anything higher than the industry average. 

For example, for most long-term investors, we argue that SPY and QQQ, the top two ETFs in today’s Trackstar top five of the ETFs investors search for most, are all you need:

SPY, managed by State Street Global Advisors, focuses its marketing on the idea that an investment in the ETF gives investors access to the broad U.S. economy. It also points out that information technology stocks compose nearly 28% of SPY’s holdings. 

No doubt, an investment in SPY gives you exposure to many of the same stocks as tech-heavy QQQ. We’re talking about Apple (AAPL), Microsoft (MSFT), Amazon.com (AMZN), Tesla (TSLA) and Nvidia (NVDA)

With SPY, you get exposure to roughly five times the number of stocks, including names you won’t find in QQQ, such as Exxon Mobil (XOM), Visa (V), Walmart (WMT) and McDonald’s (MCD)

While there’s no doubt, QQQ has produced superior returns over time, this is largely because of its tech-heavy concentration. We believe tech will continue to lead this market, in part because of the AI boom, but this doesn’t mean you should ignore all other sectors.

SPY’s expense ratio is 0.09%. QQQ is 0.20%. 

Which brings us to active ETFs. Earlier this year, we defined active ETFs in The Juice where we discussed SCHD and VYM:

That is the fund manager selects stock they think will perform well based on their knowledge, market conditions and developments in individual stocks.

This is why active ETFs tend to be expensive with an industry-average expense ratio of 0.68%. Granted, that’s down from 1.08% in 1996, but still high. 

As we circle back (we hate when people say that) to the inflow data, a few points:

  • Active ETFs have exploded in number in the last few years, which helps explain their increasing popularity. 
  • The subsequent competition has helped bring expense ratios down. 
  • It’s encouraging that low-cost, passive ETFs still reign supreme. 
  • It’s equally as encouraging to see middle-ground, passive ETFs lose luster. Because what’s the point of paying more for a passive product from, say, a lesser known fund company, when one of the big boys (e.g., Vanguard, Schwab, Fidelity) can take care of all your needs.  
  • It’s a bit scary to see people pile into active ETFs

Active ETFs often get away from making the straightforward argument of generating investment returns via a diversified slate of holdings — the sound arguments SPY and QQQ make — getting into far more speculative and subjective areas. They’re leveraging emerging themes, hot areas of the market, areas of the market people think will one day be hot and even people’s concerns around environmental and social issues, such as climate change and gender. 

The Juice touched on this when we answered the question, Should You Invest In The Hottest Thematic ETFs:

In terms of top trends in terms of popularity. This is where you have to be careful. Sort of. 

One of the most popular thematic trends of the month is Equality, Inclusion & Diversity. Within it, you’ll find ETFs such as the SPDR MSCI USA Gender Diversity ETF (SHE), which tracks the MSCI USA Gender Diversity Select Index, and the Fidelity Women’s Leadership ETF (FDWM), which is an actively-managed fund. 

SHE’s holding slate looks like a who’s who of the stock market with everybody from AMZN to MSFT to Apple (AAPL) included. SHE is up about 13% YTD. Meanwhile, FDWM is up 12% and owns a broad array of names ranging from MSFT to Mastercard (MA) to Salesforce (CRM). Not the all-star assortment of SHE, but still a pretty well-known and impressive batting order. 

But, here again, why get cute when you can get the broad market in SPY (up ~17% YTD) and QQQ (up ~42% YTD) and you can get at AI via the VanEck Semiconductor ETF (SMH) (up ~50% YTD)? 

The Bottom Line: We stand by this take today. And we wonder, are financial advisors the ones getting their clients into active ETFs? And, if so, why? 

Once you move beyond SPY and QQQ, the next logical step is dividend ETFs. And maybe a broad sector, such as semiconductors, to play AI. But, really, should you be “playing” anything? 

Broad-market tracking passive ETFs, such as SPY, QQQ and the big, low-cost funds that track the same or similar indices, get you into the names not only driving AI, but driving the economy. The now household names that have been around forever and don’t appear to be going anywhere anytime soon.

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