Financial Literacy Investing

From The Wall Street Journal: Active vs. Passive ETFs: How They Stack Up

BY Spectrum Wealth Management | Jun 20, 2023
By Derek Horstmeyer
June 1, 2023

A lot of research has highlighted how actively managed mutual funds have underperformed passive mutual funds across all publicly traded asset classes over the past 20-plus years. What about actively managed exchange-traded funds? They are a relatively new invention, but can the same be said about them?

Examining six asset classes, we see slightly better results for active ETFs than for active mutual funds. But only slightly. In just two of the six groupings (fixed income and value equity) did active ETFs outperform passive on a total-return basis, on average. And on a posttax-return basis, only the actively managed value equity ETF category bested its passive counterpart.

My research assistants, Sean Prendergast and Zhuo Chen, and I pulled data on all dollar-denominated ETFs over the past five years. We focused on this timeline since most active ETFs have been created in the past five to 10 years.

Next, we separated them into active and passive and by their asset groupings: fixed income, large cap, international equity, small cap, growth equity and value equity. Within these groupings, we recorded the average return over the past five years, the average posttax return and the average expense ratio.

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Across four of the asset classes (large-cap equity, international equity, small-cap equity and growth equity), passive ETFs outperformed active on a raw return basis. For instance, the average passive large-cap ETF delivered an annualized return of 8.81% over the past five years, while the active counterpart delivered an average annualized 7.07% over the same period. This yields an annualized difference of 1.74 percentage points for the passive ETF.

On a post-tax basis, the results favor the passive ETFs even more—five out of the six categories go to the passive ETF grouping. And for fixed income, the results actually flip. Active fixed income had an average raw return of 1.20% a year compared with 1.06% for the passive grouping. Yet, after taxes, active fixed-income ETFs had an average return of 0.63% compared with 0.78% for the passive ETF grouping. This flip occurs due to the more active trading (and hence greater taxes) that active ETFs incur.

Expense ratios play a part in these results, too. The average active ETF had an annual expense ratio of 0.57%, compared with 0.26% for the passive ETF. This creates a situation in which the active ETFs start off lagging behind the passive funds by 0.31 percentage point a year just due to those higher costs, hampering their returns to investors.

As a control against factors that possibly have clouded the results, we repeated our analysis zeroing in on a comparison of passive and active ETFs that use the same benchmarks—and we got the same results. Five out of the six categories again saw the passive ETFs beating the active ETFs on a posttax basis.

So, while active ETFs fare a little bit better than active mutual funds when it comes to comparing returns against their passive counterparts, it still isn’t too pretty a story. In all but one category, passive ETFs deliver a higher posttax return than active, and that can add half a percentage point a year in returns to an investor’s portfolio.

This article was originally published in The Wall Street Journal on June 1, 2023, and written by Derek Horstmeyer. Image courtesy of Alex Nabaum/WSJ.


Spectrum Wealth Management, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Additional information about Spectrum’s investment advisory services is found in Form ADV Part 2, which is available upon request. The information presented is for educational and illustrative purposes only and does not constitute tax, legal, or investment advice. Tax and legal counsel should be engaged before taking any action. The opinions expressed and material provided are for general information and should not be considered a solicitation for purchasing or selling any security.