From an investors strategic point of view, Exchange Traded Funds (ETFs) are created to trace indexes. ETFs come in all sorts and sizes, and allow investors to track almost every index known to man; they contain all the advantages that are typically associated with index funds, including low turnover, being inexpensive and offering a broad variety, in addition the expense ratios of ETFs are lower than traditional mutual funds. While passive investment strategies are always a popular course to follow, there are other strategies. Today we are looking into ETF investing strategies, in order to gain more insight on how these tools are used by investors.

Passive Investments

Initially, ETFs were created to offer a single security in order to trace an index and trade it intraday. Intraday trades enable the buying and selling by investors, of all the securities that make up a complete market (For example Nasdaq or S&P 500) with one trade. While doing so it offers the flexibility to get in or out of any position at any given time of the day, as opposed to mutual funds, which can be traded only once per day.

While the intraday trading option is a blessing for most traders who are active, for passive investors, the advantages are much less, and the intraday trading capability is merely a comfortable extra, because passive investors prefer buying, and holding on to it, which is still quite effective as a strategy; all the more, if we consider the fact that 80 percent of the managed mutual funds will not succeed in surpassing the benchmarks. Overall, ETFs deliver a comfortable and inexpensive means to apply indexing, or passive management to ones portfolio.

Active Trading

Despite the history of indexing, settling for average returns is something most investors will not be satisfied with. Even with the knowledge that only a mere 20 percent of funds will be able to beat their benchmarks, they will do their best to get in on that piece of the market, and for this purpose ETFs are a perfect means. Because of the option for intraday trading, traders will have the option to trace the heading of the market, through the EFTs, and act upon those developments. Even though the actual trading is still done, as passive investing, these traders, can quickly respond to short term developments. If, for example the S&P goes up rapidly, upon opening of the market, these traders can jump aboard instantly, and share in the profits.

In short, all of the active trading advantages of regular stocks, can be applied, using ETFs, including selling short, marginal buying, sector rotation and market timing.

The flexibility of ETFs, makes them excellent utilities for active trading, but they may become even more suitable in time, as another factor may soon emerge into the equation, in the shape of professionally managed ETFs.

Actively Managed ETFs

While ETFs are created for tracing an index, they could also be created for tracing the top selection of a reputable investment manager’s portfolio, with ease. ETFs can easily be created for mirroring an established mutual fund, or trace a specific investment objective. Besides how EFTs are traded, they can supply traders with investments that are geared towards providing above average returns. While the number of mutual funds is still higher than the amount of ETFs that are actively managed, their popularity is increasing rapidly in the US.

ETFs that are actively managed potentially can provide advantages for both; mutual fund investors and fund managers. In case an ETF is created to mirror a specific mutual fund, the intraday trading option, will stimulate regular traders to go for the ETF, where they would have normally gone for the fund. This in turn reduces the stream of money going in and out of the fund, and this makes the portfolio more manageable, which is more cost effective. The result is a mutual fund, with enhanced value for its investors.

Transparency and Arbitrage

ETFs that are actively managed, are not wide spread, due to the fact that they are technically challenging to create. The main problem being a trading complication, which is known as arbitrage for ETFs.

Due to the fact that ETFs are traded on the stock exchange, disparities of the price are always potentially there, and can occur between the trade price of the ETF shares and that of the underlying securities. This in turn sets things in motion to make arbitrage possible. If an ETF share is being traded below the value of the underlying securities, investors can take advantage of it by purchasing shares, and cashing them for “in kind distributions” of shares of the stock underneath. If the situation is the other way around, investors can pass the ETF by and purchase the shares of the underlying stock direct.

In order to keep the price of the ETFs close to that of the shares underneath, arbitrage is used. This is effective, due to the fact that all parties involved know the holdings in a particular index. The index ETF has no reason not to disclose the holdings, and price parity is good for all parties involved.

In case of actively managed ETFs this would be a different story, as there would be a manager, employed to select the stocks. Ideally those selected stocks will contribute to outperforming the ETFs benchmark index. In case the ETF revealed its holdings often enough for arbitrage to occur, the advantages of the ETF would be rendered useless, as investors would simply wait for the next holdings update, and go straight for the underlying stock, avoiding the funds added cost to cover its expenses. Needless to say, that in such a situation there would be no reason to create an actively managed ETF.

In Germany a bank has recently developed an actively managed ETF, that  reveals its holdings to investors daily, but with a delay of 48 hours, and the information, is shared with the general public after one month. This way, the traders are able to arbitrage the fund, but the general public receives only outdated information. However, this would not go down well in the United States, where favoring  institutions over individuals is frowned upon, especially due to scandalous experiences in the past.

Conclusion

Both, active and passive management strategies, are sound investing strategies for ETF investors, and are often applied, while the actively managed variant that is managed by professional managers is still rare. One can rest assured, that management organizations are working hard to iron out the kinks, in order to make this product available to all traders globally.

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