The Fork in the Road: Choosing Between Active and Passive Investing
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Growing up, I was always 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, or 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, choosing 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 success or setback.
These days, the same might be said about exchange-traded funds (ETFs). While the original ETFs that launched over 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 now offers a fork in the road. Investors face two paths: the traditional, passive path or 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 involves holding multiple securities that represent the entire market (like the S&P 500 Index) without much regard to the merits of individual businesses or companies, giving you a highly diversified portfolio.
Passive investing is often celebrated for low costs, with some passive ETFs costing under 0.05% 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 due to market volatility. As long as the destination is financial freedom, so be it.
Active investing takes a different path to aim for a similar outcome. Instead of buying every investment in a given category, active investing attempts to separate 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 be a better choice. Active investing requires effort: active managers need to carefully analyze businesses and map out prospects, in order to deliver true value to investors.
Actively managed products typically carry higher management fees since research and an investment process are required. These are justified so long as the net return is superior to the passive outcome. Active investing focuses on the journey as well as the destination: it tries to manage the potholes and speed bumps on the road and attempts to avoid 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 Inc. (TDAM) offers an ETF, the TD Global Technology Leaders Index 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 constituents to ensure exposure to both traditional technology (for example, software and semiconductors) and leading-edge technology (for example, robotics and artificial intelligence). This hybrid-style ETF could be considered passive and active, since the portfolio changes over time.
How about a low-turnover portfolio with an options overlay? In the active ETF category, TDAM offers the TD Active Global Enhanced Dividend 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. Layers of active management, as well as a strong track record, present an interesting option for global equity exposure, offering the potential for both yield and capital gains.
The final page
When I used to read the Choose Your Own Adventure books, I was always obsessed with taking the right path. I'd try to hedge my decisions and dog-ear the pages to ruin, so concerned with optimizing my journey that I'd use all my fingers as bookmarks, hedging my decisions so I could flip back and potentially make a different choice.
Consider the same approach when it comes to investing. When 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 & 98). Consider purchasing both active and passive ETFs together.
These days, we have investment solutions that combine a number of passive ETFs in one solution, immediately diversifying portfolios and lowering costs. These can serve as core building blocks for your portfolio. Buy and hold and watch your assets grow over time but consider active ETFs on the periphery to add the potential for a smoother ride.
Whether our portfolios turn left, or our accounts turn right, we're still on the journey if we combine index and active ETFs: we get the best of both worlds, and all the benefits of each, offering the potential to enjoy both the adventure and the destination.
For more information on TD ETFs, please visit our website.
Trevor Cummings, Vice-President, ETF Distribution, TD Asset Management Inc.
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