One way to classify an ETF is through the kinds of assets it holds. The most
popular type is the stock ETF. The underlying portfolio consists of stocks or assets that convert into stocks. You can also buy shares in ETFs that invest in bonds, currencies and commodities, including precious metals. In addition, you can select ETFs based upon their trading strategies. The two basic types are passively managed and actively managed funds.
These funds tie their portfolios to established indexes, such as the S&P 500. Index ETFs are by far the most popular type, with well over 1,000 available in the U.S. The manager of an index ETF purchases and sells securities in a way that mimics the performance of the fund’s index. This means holding the same assets (or derivatives of the assets), in the same proportions, as those found in the index. An index ETF removes the manager’s asset-selection function, which instead becomes a purely mechanical exercise.
The only time an index portfolio needs to change is when the underlying index also changes, by either adding or dropping index members. For example, the stock in the S&P 500 with the lowest capitalization – the total value of the outstanding shares – is “on the bubble.” This means that another stock might increase its capitalization and displace the stock on the bubble. When this happens, ETFs tied to the index must update their portfolios to reflect this change.
Passive ETFs have certain benefits:
They are cheaper to own. Since you are not paying a high-priced wizard to select winning stocks, you can expect a much lower management fee. Some index ETFs boast of management fees below 0.1 percent
You’ll never underperform the index. You know that your return will match that of the index.
It’s easier to maintain a long-term commitment to an index fund. When
you own an actively managed fund that underperforms the market, you might be tempted to switch to another investment or simply stop investing. Long-term gains require a long-term commitment, and if you own an index ETF, you’ll never have to worry about underperforming. This might give you the fortitude you need to weather a down market so that you can reap long-term gains.
Actively Managed ETFs
Actively managed ETFs are trickier. You choose this type of ETF if you want to “beat the market” – that is, receive returns in excess of those provided by the market indexes. While this is possible, the attempt will be costly and risky:
You will generally pay a higher fee for an actively managed ETF. The manager is (presumably) devoting considerable resources to picking stocks and timing trades in order to outperform the indexes. And don’t forget, you are paying the manager’s salary.
Very few actively managed ETFs, or mutual funds, consistently outperform the indexes. Why pay extra for punk performance?
Management can change over time. You might have found a winning actively managed ETF, but you have no assurance that the genius running the fund will still be there in the months and years ahead. This isn’t a problem with index funds.
Nonetheless, if you have a tolerance for the additional risk, you might want to include actively managed ETFs in your overall investment portfolio. Whatever your choice, remember that past performance is no guarantee of future returns .