Benefits, Disadvantages, and the Role of Active ETFs – Ramsey Crookall

Exchange-traded funds are popular across the investment community as a means of providing access to a wide range of financial assets, usually at low cost. They trade in a similar fashion to stocks and shares, where you can buy and sell at any time during the trading day. Most exchange-traded funds (ETFs) attempt to track the performance of an underlying index, such as the FTSE 100. This structure allows investors to gain exposure to a broad market segment with a single purchase. ETFs have been in existence since the early 1990s and, following significant growth, now represent about 30% of the annual trading volume on U.S. exchanges.

There are two main types of ETFs available. Physical ETFs tend to hold the underlying constituents of an index and are, therefore, more transparent than alternative structures and carry limited counterparty risk. Synthetic ETFs, meanwhile, use derivatives to replicate the return of an index and, thus, introduce a degree of counterparty risk, for which investors are compensated through lower costs and tracking errors.

One of the primary benefits of owning ETFs is easy access to a diversified portfolio of assets. By holding a basket of securities, ETFs reduce the risk associated with investing in individual stocks. Additionally, ETFs provide a source of liquidity, as they can be bought and sold throughout the trading day at market prices. This provides greater flexibility compared to open-ended funds, where the unit price is set at a fixed time each day. ETFs also tend to have lower expense ratios than open-ended funds and commonly disclose their holdings daily, providing greater transparency for investors.

However, there are also disadvantages to owning ETFs. While they have lower expense ratios, investors may incur trading costs, such as commissions and bid-ask spreads, when buying and selling shares. ETFs are also subject to market risk, meaning their value can fluctuate with the overall market, potentially leading to losses during market downturns. Additionally, there can be slight deviations from the index performance, known as tracking error, due to factors like fees and imperfect replication. Some ETFs, especially those that use leverage or invest in derivatives, can be complex and may not be suitable for all investors.

A more recent concept that has arrived on the investment scene is the Actively Managed ETF, which has similar characteristics to a passive fund except that the manager seeks to deliver returns that exceed their reference benchmark, whether that be a specific index or a desire to target certain investment outcomes. In short, an active ETF offers relatively cheap access to markets while providing what you want from an active manager.

However, active ETFs generally have higher expense ratios than passive ETFs due to the costs associated with active management. The performance of an active ETF is heavily dependent on the skill of the portfolio manager, and poor decisions can lead to underperformance. Active management also introduces an element of unpredictability, as the fund’s holdings can change frequently based on the manager’s decisions.

Incorporating active ETFs into an investment portfolio can provide a balance between passive and active management. They offer the potential for higher returns while maintaining the benefits of ETFs, such as liquidity and transparency. However, investors should carefully consider the higher costs and manager risk associated with active ETFs.

The dealing team at Ramsey Crookall are highly experienced in trading ETFs and a range of onshore and offshore funds and can be contacted by e-mail at dealers@ramseycrookall.com or by telephone at +44 1624 623884.

“This article is for informational purposes only and does not constitute financial advice. Should you invest, the value of your investment may rise or fall, and your capital is at risk. Investors should conduct their research or consult with an investment adviser before making any investment decisions”.