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By Maurits Pot

Actively managed ETFs (exchange traded funds) are a rapidly growing segment of the ETF industry. The majority of ETFs are passively managed and have grown in popularity by offering market exposure in return for very low fees. However, it is becoming apparent that in certain cases an active strategy is more appropriate.

In this post, we explain the difference between active and passive ETFs, as well as the benefits, and pros, and cons of actively managed ETFs.

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Active vs passively managed ETFs

The majority of ETFs are passively managed and constructed to track the performance of an index by replicating the index. Changes are only made to the fund when the index is rebalanced, or when securities are added to or removed from the index.

By contrast, a fund manager manages the holdings of an actively managed ETF. The fund manager makes active investment decisions on an ongoing basis and adjusts the portfolio's holding when necessary. A team of analysts typically supports the fund manager and conducts in-depth research.

The objective of passively managed ETFs is to deliver the index's performance (known as beta) with minimum tracking error. By contrast, active managers aim to generate alpha by outperforming an index. To generate alpha, the fund manager must select securities that outperform the index. Fund managers can decide which securities to invest in, how much of the fund to invest in each security, and when to enter or exit a security.

Stock picking is typically focused on securities that are undervalued or likely to perform well in the current economic environment.

Actively managed ETFs vs mutual funds

ETFs are investment vehicles that are themselves listed on stock exchanges like the shares of companies. Investors can buy and sell shares of an ETF through a stock trading account, whether directly or through a stockbroker. ETFs trade throughout the day and prices fluctuate accordingly. In practice, prices tend to closely track the NAV (net asset value) of the fund as a designated market maker manages the bid-offer spread.

Mutual funds are similar to ETFs but have a different legal structure. They do not trace on exchanges, so the fund’s price does not fluctuate during the day. Investments and redemptions are made at the fund’s NAV at a specific time each day.

Historically most mutual funds were actively managed, while most ETFs were passively managed. However, this is changing with the introduction of more active ETFs.

Mutual funds were historically also associated with higher fees than many ETFs, which has since also spurred the growth in ETFs as investors seek cheaper investment vehicles.

Actively managed non-transparent ETFs

Some fund managers have been reluctant to launch active ETFs due to the issue of transparency. Until recently, the holdings of every ETF were published daily. This meant that a manager is essentially publishing their investment decisions on a daily basis. In doing so they are revealing their strategy and letting the market know which shares they are likely to be buying and selling in the near future.

To solve this problem, a new category of ETFs has been introduced. Actively managed non-transparent ETFs, or ANTs, are ETFs that only disclose their holdings on a quarterly basis. ANTs are still relatively new, but it is hoped that their introduction will encourage fund managers to launch more active ETFs.

Pros and cons of actively managed ETFs

Until recently, the primary advantage of ETFs was the ability to earn market returns while paying low fees. Now, with actively managed ETFs, investors have the chance to earn market-beating returns. While there is no guarantee that an active fund will outperform its benchmark, passive funds cannot generate outperformance.

Active ETFs also offer a few other advantages:

• Active ETFs offer investors certain tax advantages when compared to a discretionary portfolio.
• In many cases, active ETFs charge lower fees than similar mutual funds.

In addition, there are a few risks and drawbacks that investors should keep in mind:

• Liquidity can be a challenge if a fund invests in less liquid markets.
• Some ETFs are launched when a particular industry or theme is very popular, and the universe of securities is in bubble territory. When this happens, subsequent returns can be disappointing. This can affect both actively and passively managed ETFs – examples have included 3D printing and cannabis funds.
• If the target universe for an ETF is too narrow the fund manager may struggle to find opportunities or diversify adequately.

Why invest in actively managed ETFs?

For exposure to the broad equity market, a passive ETF that tracks an index like the S&P500, FTSE 100, or MSCI World index can be sufficient, especially when considering these funds tend to charge very low fees.

On the other hand, for more specific market segments or for investors prepared to take a little more risk, actively managed ETFs may be more appropriate. When a market is new or evolving quickly, standard indexes can be limiting. Active managers are better placed to exploit inefficiencies and manage liquidity and risk. This applies particularly to emerging economies and industries where liquidity and the number of opportunities may otherwise be limited.

Conclusion

Until recently ETFs have been all about low-cost passive management. But there is also a place for active management, and for certain market segments, actively managed ETFs may be a more appropriate choice. It’s likely that the number of actively managed ETFs will continue to grow rapidly in the years to come.

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