podcast

The Fork in the Road: Choosing Between Active and Passive Investing

Published:10/09/2020


Investor Knowledge +clock5 Minutes = Confident Investing


The Fork in the Road: Choosing Between Active and Passive Investing

Growing up, I was fond of the Choose Your Own Adventure books, which transported me to wondrous places. I assumed the role of an adventurer and found myself in the Amazon, in space, even in a submarine under the ocean. Wherever I ended up, these books allowed me to skip pages instead of reading them cover to cover. I could jump around as much as each story dictated. I could choose which paths to take, with seemingly endless choices. As an astronaut, do I land on an asteroid by turning to page 38 or do I answer a distress call on a nearby planet by turning to page 57? Every choice meant a new fork in the road; a new path that would result in my success or setback.

These days, the same might be said about ETFs. While the original ETFs that launched 30 years ago were passive, active ETFs are gathering assets and growing very quickly in Canada. We are using active ETFs more than any country in the world, and the ETF industry is presenting a fork in the road. Investors are facing two paths: the traditional, passive path and the newer, active path.

Different paths to the same place?

Passive investing involves several elements. As the name implies, passive investing follows a buy-and-hold methodology; an approach with little to no turnover in investments. Passive investing often holds highly diversified investments that invest in the entire market without reviewing the merits of individual businesses or companies. Instead, every security in a category is held; sometimes tens of thousands in a single ETF.

Passive investing is often celebrated for low costs, with some passive ETFs costing under 0.1% in annual management fees. If we map out the road to our investment goals, passive investing typically downplays the journey for the destination, even if the journey is downright disagreeable because of market volatility. As long as the destination is financial freedom, so be it.

Active investing takes a very different path to a similar outcome. Instead of buying every investment in a given category, active investing separates the wheat from the chaff by evaluating companies on their individual merits.

Let's say two companies operate in the same industry, but only one is profitable. If the profitable company also has growing sales and a loyal clientele, investing in that company might seem like the better choice. Active investing requires effort. Active managers need to carefully analyze businesses and map out future prospects to deliver true value to investors.

Since careful evaluation is required, actively managed products typically carry higher management fees. These are justified if the net return is superior to the passive outcome. Active investing focuses on the journey, as well as the destination. It manages potholes and speed bumps in the road and avoids detours that might lengthen the journey.

Roads converge

The lines between active and passive ETFs are blurring. Consider a bespoke index ETF that evolves over time. TD Asset Management (TDAM) offers an ETF (TSX:TEC) that tracks a custom technology benchmark. We designed this index with Solactive, one of the largest ETF index providers in the world. Solactive administers the index and runs the quarterly rebalancing, but both parties meet annually to review the index contents and ensure we are capturing traditional technology exposure (for example, software and microchips), as well as leading-edge technology (for example, robotics, genetics and cloud computing). This hybrid-style ETF could be considered passive and non-passive since the portfolio changes over time.

How about a low-turn portfolio with a high-turn options overlay? TDAM also offers an ETF (TSX:TGED) that buys and holds a narrow portfolio of high-conviction, well-operated global companies. This ETF seeks to add value by generating additional yield via call and put options. Many layers of portfolio turnover, as well as a strong start, enhance both yield and capital gains.

The final page

Whenever I read the Choose Your Own Adventure books, I was obsessed with taking the right path. I'd try to hedge my decisions and dog-ear the pages to ruin. I was so concerned with optimizing my journey, I'd use all ten of my fingers as bookmarks so I could flip back and make a better decision.

Consider the same approach when it comes to investing. When you are faced with purchasing active or passive investments, don't choose. Build a portfolio that reduces fees by investing in low-cost index investments, but also uses active ETFs that take advantage of inefficient markets. Create a model that focuses one eye on fees and the other eye on value, net of fees. Don't put a fork in the road (or a finger on page 45, 66 or 98). Consider purchasing both active and passive ETFs.

These days, we have investment solutions that combine passive and active ETFs in one click, immediately diversifying portfolios and lowering costs. Whether our portfolios turn left or our accounts turn right, we're still on the right path if we combine index and active ETFs. We get the best of both worlds, and all the benefits. We enjoy both the journey and the destination.

Trevor Cummings
Vice-President, ETF Distribution
TDAM

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