Investment Ideas

ETFs Explained #1: Similarities of active and passive ETFs

ETFs Explained #1: Similarities of active and passive ETFs
Published: 12/07/2024

Exchange-traded funds (ETFs) are investment vehicles that bundle securities into diversified pools. They are bought and sold on an exchange, like a stock, giving investors access to markets and their money throughout the trading day.

The growth of ETFs has meant that different types of ETFs are now available including passive and active ETFs. While passive ETFs aim to replicate the performance of an underlying index such as the S&P 500, active ETFs are designed to outperform a benchmark or achieve a specific outcome and we see demand for active ETFs surging.

As actively managed ETFs gather pace, we look at the similarities and differences to their passive peers in our ETFs Explained series. In this episode, we will delve into the common features of active and passive ETFs.

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ETF is just a vehicle

An ETF is just a wrapper. Regardless of whether it’s active or passive – it presents the same benefits.

As the name suggests, ETFs are traded on an exchange regardless of the investment strategy. A variety of “engines” or strategies can therefore be placed in the ETF structure to leverage the benefits of this vehicle.

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ETFs are transparent

ETFs are traded on an exchange intraday and their market prices are updated through the trading day. After the market closes, an end-of-day net asset value (NAV), i.e. the value of a single share of an ETF, is calculated, based on the closing prices of the ETF’s underlying securities plus cash and less management fees and expenses. The market price of an ETF generally stays close to its NAV.

In addition to providing transparency on market price and NAV, most active and passive ETFs typically disclose full portfolio holdings daily, allowing every investor to know what exactly they own. However, there are also semi-transparent and non-transparent active ETFs that are not obligated to publicly reveal their entire portfolio composition on a daily basis. Always check with the issuer of the ETF and see the details they provide on their website.

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ETFs are liquid

Liquidity - describes how quickly and easily an investment can be traded without significantly affecting the price.

The liquidity profile of any ETF is driven by its underlying securities. In other words, if the underlying securities are liquid, the ETF will generally be liquid.

Both active and passive ETFs need a dedicated capital markets team which has relationships with a diversified set of market makers such as trading firms and investment banks. These market makers form their own view of the net asset value of the ETF and provide bids and offers in the market around that value.

A tighter bid-ask spread means more liquidity. Some larger ETFs with longer history have tighter spreads compared to the newer and smaller ETFs. As more investors look at investing in ETFs, we expect the liquidity to continue to improve. For example, in the US, where active ETF adoption is higher and more trading takes place on the exchange, there are several examples where active ETF spreads are on par with passive ETFs.

The issuer’s capital markets team will generally be able to provide assistance, particularly when it appears that there is not enough depth in the market.

Further, the real-time trading feature of ETFs provides intraday liquidity, allowing investors to execute trades throughout the trading day.

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Provided for information only based on market conditions as of date of publication, not to be construed as offer, investment recommendation or advice. Forecasts, projections and other forward looking statements are based upon current beliefs and expectations, may or may not come to pass. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecast, projections or other forward statements, actual events, results or performance may differ materially from those reflected or contemplated.

Diversification does not guarantee investment return and does not eliminate the risk of loss. Yield is not guaranteed. Positive yield does not imply positive return.

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