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Exchange traded funds (ETFs) were originally created to passively track indices, and to this day index-based strategies make up the lion’s share of ETF assets.
But for several years now, actively managed ETFs have been making inroads into the portfolios.
An active ETF is managed by a portfolio manager who employs their own specific strategy. They can provide exposure to fixed income, equity, balanced and alternative mandates, as well as different geographical regions. Active ETFs are designed to seek better risk-adjusted returns, improve risk management and provide diversification.
Selecting the right active ETF for your portfolio requires a bit more work than choosing a passive index strategy.
Doing thorough due diligence when selecting actively managed ETFs is a crucial step in the investment process. It involves a comprehensive analysis of various factors to ensure you choose an ETF that is aligned with your investment objectives and risk tolerance.
Here is a detailed breakdown of the due diligence process:
1. Clearly define your investment objectives
Start by articulating your investment goals. Are you looking for long-term growth, income, capital preservation or a combination of these? Your objectives will guide your selection process.
2. Understand the investment strategy
Active ETFs are managed by portfolio managers who aim to outperform a specific benchmark or index. Different ETFs employ various strategies, such as value, growth, dividend-focused or sector-specific approaches. Ensure that the strategy of the ETF you’re considering aligns with your investment goals.
3. Evaluate historical performance
Examine the ETF's historical performance over various timeframes. Look for consistency and evaluate how it performed in different market conditions. While past performance is not indicative of future results, it can provide insights into the fund manager's skill and the ETF's track record.
4. Analyze expenses and fees
Active ETFs typically have higher expense ratios than their index-tracking counterparts. These fees can erode returns over time, so it's essential to evaluate whether the potential excess returns justify the expenses. Lower fees can have a substantial impact on long-term returns.
5. Review portfolio holdings
Study the ETF's portfolio holdings to understand what stocks or assets it has invested in. Consider whether these holdings are aligned with your investment goals. Diversification and sector exposure are crucial factors to consider, ensuring that your portfolio remains balanced.
6. Assess fund manager expertise
Research the fund manager's expertise, experience and track record. The manager plays a pivotal role in executing the ETF's investment strategy. A strong, experienced manager is more likely to make informed investment decisions.
7. Examine turnover ratio
The turnover ratio, found in the Management Report of Fund Performance (MRFP), indicates how frequently the fund buys and sells assets within its portfolio. Higher turnover can result in higher transaction costs and potential tax implications. Assess how the turnover affects the fund's returns and evaluate its impact on your overall strategy.
8. Consider risk factors
Evaluate the ETF's risk profile. Active ETFs may have different risk factors compared to index ETFs. Consider how the fund manages these risks and ensure they align with your risk tolerance.
9. Income generation and dividend yields
If you are seeking income, pay attention to the ETF's dividend yield or distribution history. Active ETFs may employ various approaches to income generation, so it's essential to assess their income potential. Is income being generated purely from underlying securities? How much return of capital has the ETF paid historically?
10. Liquidity and trading volume
Assess the ETF's liquidity and trading volume. Ensuring that the ETF is sufficiently liquid is crucial, as it allows you to buy and sell units without significant price disruptions. Low liquidity can lead to wider bid-ask spreads and increased trading costs. Of course, an ETF’s liquidity is primarily based on its underlying holdings, rather than the average daily trading volume of the ETF itself. For more on ETF liquidity, see our article {ETFs and liquidity | Mackenzie Investments}
11. Understand tax efficiency
Examine the tax implications of the ETF. Active management can result in capital gains distributions, which can have tax consequences. Investigate the ETF's tax efficiency based on historical tax factors available on an ETF provider’s website. To learn more about some of the factors that can affect tax efficiency, read our article {Tax considerations for ETF investors | Mackenzie Investments}
12. Regulatory filings and prospectus
Carefully read the ETF's prospectus and regulatory filings. These documents provide detailed information about the fund's objectives, fees, risks, and other important details that are essential for informed decision-making.
13. Evaluate the structure of the ETF and its impact on total cost of ownership
Consider whether the ETF is a stand-alone trust or is part of a mutual fund series (ETF series). Within an ETF series, costs are mutualized across all investors (similar to a mutual fund structure), however investors of ETF series would still have to pay spread and commission costs when entering/leaving the ETF. Within a stand-alone ETF, costs are typically not mutualized as investors pay their trading costs when buying or selling units of the ETF {ETF Series | Mackenzie Investments}.
14. Consider current market conditions
Take into account the prevailing market conditions. Some active strategies may perform better in specific market environments, and it's important to evaluate whether the ETF's strategy is well-suited to the current market conditions.
15. Compare multiple options
Don't limit your due diligence to a single ETF. Compare multiple options within the same category to find the one that best aligns with your investment objectives and risk tolerance. Use online tools and resources to facilitate your comparison.
Due diligence is not a one-time task but an ongoing process. Regularly monitor your investments, stay informed about changes in the ETF's strategy or management team, and be prepared to adjust when necessary. A well-researched and diversified portfolio is key to achieving your long-term financial objectives.
Explore Mackenzie’s line of active ETFs, made by Canadians, for Canadians.
Commissions, management fees, brokerage fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated.
The content of this article (including facts, views, opinions, recommendations, descriptions of or references to, products or securities) is not to be used or construed as investment advice, as an offer to sell or the solicitation of an offer to buy, or an endorsement, recommendation or sponsorship of any entity or security cited. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it.
This should not be construed to be legal or tax advice, as each client’s situation is different. Please consult your own legal and tax advisor.