Active vs. Passive ETFs: Which is Right for Canadian Investors

Exchange-traded funds (ETFs) have become one of the most popular investment methods in Canada. Many feel that in the past couple of years, these funds have replaced the practice of opening a TFSA for retirees managing RRIF withdrawals. The ETFs combine the diversification options and liquidity, which is what the investors are after.

The main dilemma for Canadian investors is now whether to invest in active or passive ETFs. In this article, we’ll explain the difference between the two and provide guidance for investors on how to choose the one that suits them, based on their circumstances.

The Canadian Context

Before diving into the difference between passive and active ETFs, we should explain the Canadian investment context and how it differs from similar countries.

Being pooled investment funds, ETFs trade on stock exchanges like individual stocks. When investors buy an ETF, they buy a bundle of securities, including stocks, bonds, commodities, and even other funds, without buying any of the assets directly. The Canadian financial sector is heavily concentrated in the domestic market, and this allows for diversification.

Canada is a pioneer in the ETF markets. The world’s first ETF was created in Canada in 1990. At this point, Canada has about $400 billion in ETF assets. Their value also grows at a double-digit rate.

The major players in the Canadian market include BlackRock’s iShares, Vanguard, BMO Global Asset Management, and new companies such as Purpose Investments and Horizons ETFs.

Crypto ETFs

Crypto ETFS are a recent introduction in the world of tradable assets. These funds allow the owners to trade with cryptos without buying any of the coins themselves. Instead, the value of the ETF remains tied to the market value of the cryptos it contains.

For a while now, crypto experts such as Cryptomaniaks have been writing about the changing nature of the crypto market. Some industries have embraced cryptocurrencies early on, such as gambling Bitcoin sites and VPN services, but in the last couple of years, traditional markets, such as stocks and bonds, have included cryptocurrencies.

What are Passive ETFs?

Passive ETFs can track the performance of a specific index or a benchmark. This means that these ETFs don’t try to beat the market, but to match it. One of such funds is the iShares S&P/TSX 60 Index ETF (XIU). It follows the 60 largest companies, which are listed on the TSX. By investing in this fund, the investor gets access to the Canadian blue-chip stocks.

Advantages of Passive ETFs

There are several advantages of using these types of ETFs:

• They are much less costly, as there’s no need for active management of the fund. The expense ratio is often between 0.05 and 0.5 percent.
• Managing and trading passive ETFs is simpler than alternatives.
• Daily disclosure of holdings ensures the funds are very transparent.
• Their performance is very reliable and easy to predict.

Limitations of Passive ETFs

As is the case with any investment option, there are also downsides and limitations to passive ETFs.

• There’s no outperformance; the investor gets market return and nothing more.
• Passive ETFs offer limited flexibility; an investor can’t react to sudden changes in the market.
• If the index isn’t balanced and if it favors a certain type of company or industry, it will be felt in the profits made from the ETF.

What Are Active ETFs

Active ETFs blend traditional ETFs and the benefits of active management. The managers use research, market timing, and security selection to try to beat the market index. The BMO Canadian Equity ETF (ZLB) and Purpose Investments’ Active ETFs are examples of active ETFs.

Advantages of Active ETFs 

There are several advantages of active ETFs that investors should be aware of:

• There’s a potential for the ETF to outperform the market, providing the investor with much more profit than they’ve expected.
• Investors can shift assets, hedge risks, and focus on specific industries or sectors.
• Some ETFs provide strategies to protect investors from downturns in the market.
• These ETFs allow for access to niche strategies such as a focus on ESG (environmental, social, governance) or dividend growth.

Limitations of Active ETFs

There are a few limitations of active ETFs that may turn some investors away:

• The fees are higher for active ETFs since they require management and decision-making, and therefore labour. The fee ranges from 0.50% to 1.00%.
• The success depends on the skill of a person managing the account, and that’s a difficult role to delegate.
• The results are inconsistent, and many active ETFs fail to outperform the market.

Long-Term Cost Comparison: MERs and Taxes

For most Canadian investors, the hidden costs of investing in ETFs are the biggest contributor to a decision on which ETFs to choose.

• Passive ETFs typically charge MERs of 0.05% — 0.25%. This means that over the period of 20 years and for a portfolio of $100,000, the cost of MERs could amount to tens of thousands of dollars.
• Active ETFs charge significantly more, usually 0.50%–1.00%. The cost is therefore proportionally higher, but still lower than that of investing in mutual funds.

When it comes to taxes, many funds have policies put in place to protect their investors from the tax burden. TFSA & RRSP shelter capital gains and dividends from tax, while U.S.-listed ETFs may face withholding taxes on dividends, even inside registered accounts.

Most Canadian investors, therefore, lean towards passive ETFs when the cost is a major objection.

Performance Trends in Canadian Markets

Past performance trends show that passive ETFs tend to perform somewhat better in the long run. For most investors, these will do better, but there are some niche markets and cases in which active ones should be taken into account. These include:

• Niche markets and active managers often outperform the market. This is most seen in sectors like technology, healthcare, or ESG.
• Active ETFs work better during market downturns.
• When the environment is volatile, active managers can adapt faster and react to that volatility.

Risk Factors for Canadian Investors

There are several risk factors to take into account when investing in either of these two types of ETFs. Some of these are unique to Canada, and others are troubling investors in every country.

Market Risk

Regardless of how an ETF is structured, it’s still susceptible to market forces and affected by them. It’s always a risk that an investor should be aware of. All industries can be affected by macroeconomic instability, and sometimes everything a person has invested for years could be lost rather quickly.

Manager Risk

ETFs, especially active ones, rely on the manager’s skills to choose the assets that comprise the fund and change them when needed. If these decisions are poorly timed or simply mistakes, the fund won’t perform well. Choosing a good manager is one of the most difficult decisions for an investor.

Tracking Error

Passive ETFs are made to track the market and to mirror an index, but they aren’t always able to do so. The difference is called a tracking error. It can happen due to management fees, trading costs, or poor sampling of assets. These often start small, but they tend to add up over the years.

Currency Risk

Canadian investors diversify their assets by holding US assets or taking part in global ETFs. Exposure to international markets can lead to profits, but it also means that the investors are affected by the changes in currency value. The work of foreign national banks mostly accomplishes this and, therefore, is out of reach of the investor.

Liquidity Risk

ETFs that are highly traded have high liquidity. That means they can be bought and sold easily since there’s a lot of demand for them. Niche ETFs that focus on small companies and small markets are much more difficult to buy or sell at any given time.

Investor Profiles – Who Should Choose Which?

Each type of ETF is suited to a different type of investor, and choosing one depends on your investment goals and objectives.

Passive ETF Investors

 This type of ETF is best suited to a novice investor. Beginner investors are the ones who are looking for a simple and easy way to create profit, without too much daily work. It’s also often chosen as a way to prepare for retirement. That’s a good solution because of the tax policy allowing the investor to keep as much of their profit once they retire.

Investors who are aware of the costs involved in investing and want to maximize their returns also choose passive ETFs. It’s often described as an option for those who believe that “time in the market” is more important than “timing the market”. Therefore, passive ETFs are a long-term and less risky investment.

Active ETF Investors

Active ETF investors are typically more experienced investors who want exposure to concrete and tactical assets, based on their knowledge of the market. It’s a smaller group, but a more prestigious one as well. It’s also a better option for investors looking to get into specialized investment strategies.

Active ETF funds are better suited to investors willing to pay the higher fees involved in managing these funds. This higher fee provides a chance for your ETF to perform well and generate significant returns. It’s generally better suited to investors who are willing to risk more.

The Future of ETFs

ETFs are changing and adapting to include different industries and assets, but the remaining principle behind them remains the same. Given that ETFs have quickly adapted to cryptos, chances are that they will also evolve as the markets do.

There are a few common trends that indicate what the future of ETFs will be, but chances are, there may be other innovations we don’t yet know of.

• Thematic ETFs – These funds cover different assets that remain tied together by a common theme. For instance, an investor could invest in an ETF focused on AI, or ETFs focused on clean energy, or those working in the field of blockchain.
• ESG growth – This refers to the assets in the fields of Environmental, Social, and Governance. These could be assets that a progressive ideology could influence. As the politics changes on a daily and election basis, these lose some of their importance, at least for now.
• Robo-advisors – This refers to the ETFs that are selected by an AI service and the input the investor provides beforehand.
• Factor-based ETFs are blending passive and active ETFs while using what’s known as rule-based investing.

Common Mistakes Canadian Investors Make With ETFs

Some mistakes are common among Canadian investors, and as long as the new investors are aware of those, they can do what they can to avoid them in the future.

Overconcentration

It refers to having too many assets of a certain type or industry within an ETF. Canadian investors often make the mistake of not diversifying their assets based on origin and focusing on too many assets based in Canada. This creates a higher risk environment.

Overpaying in Fees

Higher fee ETFs are the ones that have a better management structure with closer management in general. It’s a worthy investment to make if it brings in profit, and in many cases, the investors don’t get what they paid for in increased fees.

Chasing Performance

In many cases, the investors buy an ETF because it has recently performed well. This is most often a mistake, as investments like this aren’t for turning a profit quickly. Instead, it’s better to choose an ETF according to its long-term potential.

To Sum Up

ETFs are a common investment tool for Canadian investors; in fact, Canada was the pioneer of this approach to investing. There are two main types of ETFs, active and passive ones. These differ in how they are managed and, therefore, in how expensive they are to manage.

Active ETFs can quickly adapt to market changes and produce more profits, while passive ones are for long-term investment and are less risky.