Actively traded ETFs could provide investment benefits–but will more likely hurt your returns

When ETFs first hit the market in the 1990s, we hailed them as the most benign investment innovation we’d ever seen. They started out as a new, improved alternative to mutual funds.

ETFs are a little like conventional mutual funds, but with two key differences.

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First, ETFs trade on a stock exchange throughout the day, much like ordinary stocks. So you can buy them through a broker whenever the stock market is open, and generally you pay the same commission rate that you pay to buy stocks. In contrast, you can only buy most conventional mutual funds at the end of the day. Commissions vary widely, depending on negotiation with your broker for fund dealer.

Second, the MER (Management Expense Ratio) is generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investment. Instead of actively managing their clients’ investments, they generally try to invest so as to mirror the holdings and performance of a particular stock-market index.

ETF fans refer to this as “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher cost. This distinction, though, is somewhat misleading. Traditional ETFs are passively following the lead of whoever sponsors the index. Sponsors of stock indexes do from time to time change the stocks that make up the index, however, and they do tinker with the rules for calculating the index. ETFs change their portfolio holdings to reflect these changes, without considering any impact the changes may have on the performance of the ETF portfolio.

The three paragraphs above refer to what you might think of as “traditional” ETFs. However, when an investment product faces booming demand as ETFs do today, investment companies try to expand sales by creating new versions of the underlying formula.

Many new ETFs use a conventional stock-market index as a base, but add their own refinement. This refinement usually aims to appeal to current investor preferences or prejudices. It distinguishes the new ETF from the older, plain-vanilla variety that simply aims to mimic the index. It may attract attention in a crowded ETF field. If nothing else, it will justify a higher fee than traditional rock-bottom ETF MERs.

In some cases, the new ETF improvement may provide an investment benefit, but it won’t do so consistently. Or it may hurt results, in the long run if not in the short. The worst cases are bad enough to turn investor profits into losses. One sure result is that the higher MER will cut into the value of your ETF’s investment portfolio every year.

Meanwhile, after ETFs became established in the investment marketplace, financial institutions began adding new features to them, to add to their appeal. These new features included options trading (to produce extra income from the ETF’s holdings); foreign-exchange hedging (to cut the foreign exchange risk of holding foreign stocks); and “capping,” or limiting, the percentage value of certain types of investments within the ETF.

These additional features can add to an ETF’s cash flow or cut its volatility. However, they all wind up cutting the final profits that investors get out of the ETFs. That’s because the ETFs have to pay for all these bells & whistles (which, of course, add to the income of the financial institutions involved). But the ETFs don’t make any more net profit. Thanks to the added features, they simply add to fees, commissions and trading losses for ETFs (and thus for ETF investors) on average.

It’s a standard marketing technique: describe a feature as a benefit, while hiding or disregarding the cost. If the first addition pays off, come up with another, then a third, and so on.

Now the ETF industry has come virtually full circle. It has begun to offer actively traded ETFs, managed by portfolio managers who may also have worked on old-fashioned, conventional mutual funds.

Actively traded ETFs now make up 6% or so of the total ETF market. However, they brought in around 30% of ETF inflows so far in 2023. That’s more than twice their total for 2022, when they brought in 14% of total inflows.

Actively traded ETFs have an average expense ratio, or MER, of 0.7%, compared to 0.14% for passive funds.

Perhaps the best-known actively traded ETF manager is Cathy Wood–and her performance show the risk of actively managed ETFs. Her ARK Innovation fund invests mostly in fast-growing but money-losing technology stocks. These highly volatile stocks dominated the media and markets in the fast-rising market of 2020. That year, the ARK Innovation ETF gained 152%. It has gone sideways-to-downwards ever since, with losses of 14% in 2021 and 67% in 2022. This ETF’s unit price is now down near the market lows of 2020.

Have you been investing in actively traded ETFs? Why or why not?