ETFs are popular and getting more popular by the day and there are many reasons for this. But there are also quite a few drawbacks with ETFs. But before we get too deep, let’s review a few items.
First on the list to review is the difference between active and passive investing. This lays at the heart of the ETF “raison d’ etre”. Let’s take a look.
Actively managed mutual funds are an example of an active investment because the manager of the fund actively buys and sells stocks and/or bonds. Actively managed funds are relatively more expensive than many ETFs because of the high price the fund pays for managers and research departments (among other items). Of course these funds are never too shy to pass these costs on to you.
ETFs and index funds are passive investments because these funds do very little buying and selling. They are also very inexpensive (often costing less than 1/5 the cost of an actively managed fund) because, for the most part, they buy and hold securities. They don’t need to pay for high-priced fund managers and research departments.
Is that all you need to know?
Is cost enough to throw out actively managed funds and stick with ETFs and other passively managed funds? I don’t think so.
There are also the issues of performance and risk.
Passive investing can expose investors to great risks. That’s because passive investors buy and hold and must be willing to accept whatever the market dishes out. (If you are a passive investor, you must be willing to take whatever the market brings your way.) If you are OK with all that, passive funds are the way to go and ETFs probably are a good fit. All you have to do is buy the right ETFs.
What about active investors?
For active investors, the story is quite different. ETFs might be a good fit. But active funds might be good too. Remember, active investors have different goals than passive investors – and this is the key. They are usually very concerned about both performance and risk.
Active investors aren’t willing to take whatever the market dishes out.
They either want to beat the market when it’s good or they want to beat it when it’s bad by losing less than the market. (If you want to do both, I have bad news. Can’t be done.)
Asset allocation is one example of active investing. You shake up your portfolio by selling and buying at certain intervals. But there are other tools at the disposal of active investors. You can also use market timing strategies to some extent or the other. Timing means you buy certain funds at certain times and you sell them at other times based on some predetermined performance strategy – not based on your gut feeling or what your cousin Tim told you last week at a birthday party. Timing can be a dangerous way to invest – but it doesn’t have to be if you use a well-reasoned approach.
Why It’s OK For Active Investors To Use ETFs And Actively Managed Funds
Regardless of how you behave as an active investor, if you make investment decisions based on the performance, it just doesn’t matter if you use ETFs or actively managed funds. If the performance of the actively managed fund is far better than the ETFs’ performance in the short term, you buy the more expensive actively managed fund. If the ETF is doing better, that’s what you buy. Performance numbers always net out expenses anyway.
This explains why I use actively managed funds and ETFs. I am agnostic when it comes to investments. I just want the best performers in my portfolios.
The bottom line is: using actively managed funds and ETFs is consistent with my goals, which are to use a systematic approach to reduce risk.
Do actively managed funds have a place in your portfolio? Do you only go with ETFs? Why or why not?