Exchange-traded funds (ETFs) have transformed how investors access markets, offering diversification, transparency, and liquidity in a single trade. But not all ETFs are created equal. At the heart of the ETF universe lies a fundamental decision: should you prioritise low fees through passive investing, or try to pursue potential outperformance through active management?
Understanding when to favour one over the other is key to building a portfolio that aligns with your goals, risk tolerance, and investment horizon.
What’s the difference between passive and active ETFs?
At a high level, the distinction comes down to how the portfolio is managed.
- Passive ETFs aim to track a market index. They follow a rules-based approach, holding securities in the same proportions as a benchmark such as a broad equity index like the largest 300 companies in Australia or a bond index.
- Active ETFs aim to beat the market and do not track an index. Portfolio managers make investment decisions, such as selecting securities, adjusting exposures, and responding to market conditions, in an effort to generate excess returns above the index (often called “alpha”).
The role of fees: small differences, big impact
Fees are often the most visible but misunderstood difference between the two approaches.
Passive ETFs are typically much cheaper because they don’t require research teams or frequent trading. Average expense ratios sit around 0.36% per year for passive ETFs (i.e. $36 per year for a $10,000 investment) versus roughly 0.78% for active ETFs (i.e. $78 per year for a $10,000 investment).
The $42 per year gap in fees may seem small, but over time it compounds. Higher fees reduce net returns year after year, which is why cost is often described as one of the few variables investors can control.
Why passive ETFs have gained dominance
Passive investing has grown rapidly over the past two decades for the following reasons:
1. Consistent, market-level returns
Passive ETFs are designed to deliver the return of the market. They also avoid the risk of underperformance tied to poor manager decisions and avoids key person risk if a particular fund manager decides to leave.
2. Lower costs
With minimal trading and no need for stock-picking teams, passive ETFs pass cost savings directly to investors. Lower trading costs, reduced tax impacts, and lower overall fees all help ensure more of the returns remain in investors’ pockets.
3. Transparency and simplicity
Investors can easily understand what they own, as passive ETF holdings are typically disclosed daily and tied directly to an index. Active ETFs typically don’t disclose their full holdings and sometimes only periodically reveal them with a three-month lag.
4. Strong long-term evidence
After fees, many active managers struggle to consistently outperform benchmarks over long periods.1
For these reasons, passive ETFs often form the core of a portfolio, providing broad, cost-efficient exposure to markets.
Where active ETFs can add value
Despite higher fees, active ETFs are gaining traction. Here are a few reasons why:
1. Inefficient or complex markets
In areas like emerging markets, micro caps, or certain fixed income exposures, information may be less widely available. Skilled managers may be better positioned to identify opportunities or manage risks.
2. Flexibility
Active managers can adjust portfolios in response to market conditions, with the aim of helping to reduce volatility or tilt exposures.
3. Outcome-focused strategies
Some active ETFs are designed with specific objectives such as aiming to generate income above a certain rate or achieving a real return above inflation which may be appealing to goals-based focused investors.
When to prioritise lower fees
There are several scenarios where passive ETFs may make the most sense:
- Long-term, buy-and-hold investors: Over long horizons, compounding amplifies the impact of fees. Keeping costs low can provide the opportunity to improve outcomes.
- Efficient markets: In highly researched, liquid markets (like large-cap equities), consistently beating the index is difficult, making low-cost passive exposure attractive.
- Portfolio core allocations: For broad market exposure, passive ETFs provide a reliable and easy to implement foundation.
- Cost-sensitive investors: If minimising fees is a priority, passive ETFs offer a clear advantage.
In these cases, choosing lower fees is less about sacrificing performance and more about avoiding unnecessary drag on returns.
When active management may be worth the cost
Active ETFs may justify their higher fees in specific circumstances:
- Targeted opportunities: Where investors have strong conviction in a niche area of the market that they cannot access through a passive ETF.
- Risk management needs: Investors seeking goals-based outcomes such as downside protection or smoother return profiles may benefit from active strategies.
- Niche or less efficient markets: In areas where pricing inefficiencies exist, skilled managers may have a better chance of adding value compared to liquid efficient markets.
- Tactical allocations: Active ETFs can be used opportunistically, complementing a broader passive core.
The key is selectivity. Not all active managers outperform, and past performance is not always indicative of future results.
A blended approach: core and satellite
Rather than choosing one over the other, many investors adopt a core-satellite approach:
- Core: Low-cost ETFs providing broad market exposure
- Satellite: ETFs targeting specific opportunities or outcomes
This structure allows investors to benefit from the cost efficiency of passive investing while still allocating capital to areas where they have conviction.
For many investors, the decision comes down to a simple question: is the potential for outperformance worth paying higher fees and taking on additional risk?
Ultimately, the most effective portfolios are not built on ideology but on thoughtful allocation, where cost, conviction, and context all play a role.
