Active ETFs: What are they and do you need them?

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Active ETFs: A contradiction in terms?

ETFs are usually identified with passive investing strategies because the vast majority of them are designed to match the return of a particular market. That makes ETFs the ideal choice for everyday investors who want a transparent, low cost, buy-and-hold product. Yet, ETFs are also actively traded. Major investment banks and day traders use “passive” ETFs for this very purpose. Why? Because ETFs offer quick and efficient exposure to many different markets, and can be bought and sold instantly in response to trends, conditions, and events. Then there’s factor ETFs, which are a hybrid of passive and active behaviours. In brief, factor trackers are considered part of the passive investor’s toolkit because they strictly adhere to a rules-based index. At the same time, their USP is their potential to beat the market by targeting stocks that exhibit traits associated with historical outperformance. This is a form of stock-picking - albeit strongly evidence based - which makes it an active investing choice. However, we’re going to focus on a different phenomenon in this article: the growing trend of retooling ETFs for pure-play active investing. That means:

• The ETF’s results are driven by its management team’s choices and not the performance of an index.
• Success depends on the management team’s ability to capitalise on opportunities that enable them to beat the market over time. (This is known as “management skill”.)
• The team relies on market-timing and stock-picking strategies to add value over their selected benchmark.
• They may exercise their discretion to invest in a wider range of financial instruments and strategies than is normally the case with index-tracking ETFs.

If you think you’ve heard this somewhere before, then you’re right. The vast majority of mutual funds are actively managed this way. What’s new here is that active management strategies are proliferating in the ETF space.

Active ETFs on the rise

There are more than 1,500 active ETFs in the US, with Cathie Wood’s ARK Innovation ETF being among the most famous. (A UCITS version launched over here in April 2024 and Ark Invest have also taken over the Rize ETF range). By contrast, Europe and the UK have a long way to go to catch up. We currently have only around 200 active ETFs to choose from, although there are more in the pipeline. Naturally, most of the products are equities-orientated, while there’s a strong showing for active bond ETFs too. However, interesting ideas are coming on stream all the time including new approaches to megatrends, sustainability, risk factors, and even strategies borrowed from the hedge fund industry such as managed futures. JPMorgan is currently leading the active ETF charge in Europe. Followed by Fidelity, Franklin Templeton, Pimco and AXA IM. Traditional ETF powerhouses like Amundi, iShares and Xtrackers have also tested the waters with a few products each. Indeed, some investors will have already made their first foray into active ETFs without perhaps fully realising it. That’s because some of Europe’s popular money market ETFs have been actively managed for years.

Why are active ETFs growing in popularity?

While active mutual funds have suffered net outflows in recent years, European investors have been pouring billions into active ETFs. Why have ETFs bucked the trend?

1. ETFs have design advantages - Many investors prefer to invest entirely in ETFs and view mutual funds as an outmoded vehicle. For example, mutual funds only trade once per day. They also suffer from stale pricing, so you may not know the price you’ve traded at until the day after you placed your order. Hence, it’s hard to be responsive with mutual funds or switch investments at speed. By contrast, all ETFs benefit from near-real time, intraday pricing and trading.
2. Lower fees - Active ETFs typically cost less than active mutual funds, though they are still more expensive than index-tracking ETFs. Thus, some investors are prepared to buy into active ETFs as they may offer better value than mutual fund equivalents.
3. Superior distribution - While asset managers offer active mutual funds primarily through an established network of distribution platforms, ETFs are easily traded on the stock exchange and are more readily available through a wide range of brokers and trading apps.
4. Greater transparency - Active ETFs disclose their holdings daily in Europe, giving investors a clearer picture of where their money is allocated versus active funds. However, Europe’s dominant ETF domiciles - Ireland and Luxembourg - have indicated a willingness to loosen their transparency rules. This could lead to “semi-transparent” ETFs that do not disclose their holdings daily, or provide proxy portfolios that indicate the product’s risk exposure but not its actual positions.
5. Diversification - Some investors choose to diversify across investing philosophies as well as markets. For example, their core portfolio is built out with passive ETFs, but they devote a satellite allocation to active management in the hope it delivers on its market beating promise. Passive investors may also turn to active products because that’s the only way to access a niche market or strategy they’re interested in.

Transparency and cost are key in our view. Two of the biggest marks against active investing are: The sheer expense of active management. The bigger the cost differential between active and passive, the harder it is for active investors to realise market-beating returns. How do you know what you’re investing in? Active mutual funds are neither constrained by an index, nor required to declare their holdings. Which means they can stray far from their stated remit as their manager comes under pressure to deliver outsized returns. The upshot is, you cannot be exactly sure what risks you’re exposed to. This isn’t theoretical. The history of the mutual fund industry is littered with infamous blow-ups. In contrast, you know precisely what you’re getting with passive ETFs and can be certain it won’t change. As the active ETF market is currently shaping up, the products do mitigate those persistent problems to a degree. Does that make active ETFs better than passive? Let’s take a closer look at the advantages and disadvantages of the three vehicles…

Advantages and disadvantages of active ETFs vs passive ETFs vs active funds

The following table can help you quickly compare each product type: A few other criteria are worth thinking about. If you’re used to investing in broad market passive ETFs, then watch out for:

• Concentration risk - This materialises when the returns of a product depend on a few dominant stocks. Excessive concentration is more likely to occur in active vehicles when the manager has the freedom to make big bets and is relying on their security selection skills to outperform.
• Liquidity risk - The manager can only beat a market by investing in a superior subset of the market. It’s possible then for a manager to build a large position in obscure stocks that trade in low daily volumes on the stock exchange. Yet, investors in ETFs expect instant access to their money anytime. This expectation is comfortably fulfilled in the deep and liquid markets that underpin S&P 500, MSCI World, or FTSE 100 ETFs. Buyers and sellers are easily matched and multiple market-makers smooth trade flow. But problems may arise if there’s a large imbalance between buyers and sellers in illiquid underlying securities. In that case, bid-offer spreads can widen, pushing up the cost of trading. These are rare events and only likely to occur during extreme conditions (think major panic) but it’s worth knowing about.
• Closet trackers - A negative term applied to active funds that charge high fees but don’t sufficiently differentiate their holdings from the market position. Such funds act like expensive passive products: delivering market-like returns, but at an uncompetitive price compared to index trackers. This is the opposite problem to concentration risk but also needs to be borne in mind when assessing an active ETF. You can only beat the market if you’re prepared to diverge from the market.

In sum, active ETFs present issues that just aren’t a concern with straightforward, broad market ETFs, which is why researching actives takes more time and effort.

Key takeaway

The tantalising promise of active ETFs is their potential to beat the market at a reasonable cost. Can it be done? Yes, but the evidence suggests that it’s very difficult. That’s why, after all, we’re big fans of ETFs in the first place. All the same, some active managers do outperform, and it can be rewarding - or at least fun - to hunt for them. The key is to fully understand each product, along with unique risks, and to avoid going all-in. If you are intrigued about the possibilities of diversifying into active ETFs, then consider building your position gradually with a small initial stake. Some investors think of this as “fun money”. They use it to scratch their market-beating itch and to invest in new investment ideas that excite them. The rule is that you set a fun money limit (e.g. 5 % of your portfolio) and you don’t pump more in if your more speculative investments don’t work out. Meanwhile, the rest of your asset allocation (or all of it if you don’t buy the active hype) can remain undisturbed in a tried-and-tested buy and hold strategy.