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A guide to active ETFs

  • 22 August 2022 (5 min read)

We believe that exchange-traded funds (ETFs) will continue to play an increasingly important role in the investment landscape over the decades ahead. In this guide, we aim to help investors understand the evolving ETF marketplace, particularly in terms of differentiating between traditional passively-managed ETFs and the growing number of active ETFs on offer.

The evolution of the ETF market

Assets under management in ETFs have grown rapidly over the past 20 years1 but their origin goes back to the early 1990s. The stock market crash of 1987 drove demand for a fund structure providing better liquidity by allowing intra-day trading.

The idea which emerged was an investment fund-like vehicle pooling together a diversified basket of securities which would be placed on an exchange and traded as a single unit throughout the day, like stocks.

Traditionally, passive investments aimed to track the performance of a basket of securities or a market index. Today’s ETFs have evolved to offer investors access to a much wider range of investment strategies, including an increasing number of actively-managed funds not constrained by a benchmark allowing to provide greater returns or provide other specific outcomes.

Implementing an active strategy in an ETF format

Most investors have historically used ETFs as index trackers. This can provide a cost-effective way to gain exposure to financial markets through a simpler process than the often highly-intermediated routes to investing in mutual funds. ETFs can be bought either through trading platforms where investors can interact directly with Market Makers and Brokers  or directly through an online trading account. However, an ETF is only a ‘wrapper’, and all kinds of investment strategies can be used in the vehicle. As markets and investor demand have evolved, there have been several innovations in the ETF industry - foremost of which is the introduction of active ETFs. Rather than seeking to replicate the holdings and performance of an index, active ETFs may replicate an actively-managed model portfolio. The model portfolio could be built from a list of investments that has been chosen by a professional portfolio manager.

The portfolio manager will use their skills, experience, and other resources to select a combination of securities they believe are most likely to deliver the objectives of the fund, and to adjust the model portfolio according to changing market conditions. In an active ETF, an index or benchmark may be used for performance comparison purposes, but the aim is not to generate the index return. Rather, the aim to generate returns through active stock-picking, within an ETF vehicle.

Passive ETFs that replicate a benchmark can buy a basket of securities to achieve the same return as the benchmark (‘physical replication’), or the ETF provider can make use of derivatives such as swaps to track the index return (‘synthetic replication’). Active ETFs can directly invest in securities selected in the model portfolio.

It is the job of a dedicated Portfolio Management team to replicate the model portfolio in an ETF format.

Active ETFs may also offer the chance to access opportunities or themes that can’t be easily replicated through index investing. However, there is no guarantee an active ETF will achieve its aims, while the costs associated with active ETFs are usually higher than passive ETFs as they rely on portfolio managers’ expertise, skills and judgement for select stocks. 

The difference between active ETFs and Smart Beta ETFs

So-called Smart Beta ETFs may use filters or screens to either tilt towards or remove certain characteristics from a benchmark with the aim of improving performance over that benchmark.

Smart Beta ETFs may use tilts towards factors such as value, growth, or low volatility, or may use alternative weighting schemes such as equal weighting rather than market capitalisation to determine the weights on individual holdings. They will typically be rules-based and systematic in implementation.

An active ETF is designed to have freedom from a benchmark and allows for a portfolio manager to build an active basket of securities that may target financial as well as non-financial outcomes.

The difference between active ETFs and active mutual funds

There are more similarities than differences: Both traditional mutual funds and active ETFs are pools of investments managed by professional fund managers and generally offer exposure to a diverse range of investments in a single vehicle.

As active ETFs aim to reflect a model portfolio built and actively managed by a portfolio manager, their value won’t simply go up and down in value in line with a market index. Rather, the aim is to use their flexibility to invest only in securities the portfolio manager believes to be a good potential investment, as is the case with an actively managed mutual fund.

The key difference is that active ETFs trade on a stock exchange, which provides the following additional benefits:

  • Accessibility: ETFs are widely available and easy to trade as they are listed on stock exchanges, like shares. This provides investors with the flexibility to trade at any time during market hours.
  • Trading: ETFs offer real-time pricing and the flexibility of intra-day trading like stocks. ETFs allow the end investor to trade easily and efficiently through the secondary market (via the stock exchanges or via trading platforms where investors can interact directly with Market Makers and Brokers.), providing an extra layer of liquidity and a quicker time to market, which may be operationally more efficient for investors who need to make large allocations swiftly. Mutual funds can only be bought and sold at the end of the day and switching investments can take longer.
  • Transparency: Many ETFs are fully transparent in terms of holdings and pricing, which enables investors to easily monitor their investment.

Active ETFs combine some of the potential benefits of mutual fund investing with the convenience, transparency and liquidity of an ETF vehicle. However, like any investment product, there are risks to consider before investing in ETFs, such as market risk and investment risks such as interest rate, liquidity, company-specific, credit and concentration risk, as well as other risks specific to individual ETFs. It is vital to understand how an active ETF’s investment process and objectives align with individual investment goals and risk tolerance.

More on transparency

Some investors may believe that active ETFs are less transparent than passive ETFs but this is not always the case. In the US, some actively-managed ETFs are referred to as semi-transparent or non-transparent as they disclose portfolio holdings less frequently. However, in Europe, ETFs are fully transparent and disclose holdings daily, the same as passive ETFs.

Using active ETFs in a portfolio

Active ETFs can be used in exactly the same way as traditional mutual funds. They can be used as building blocks of a portfolio or as a straightforward way to achieve all-in-one diversification.

Although ETFs allow for frequent intra-day trading, they can also be used to achieve long-term objectives and to efficiently access specific themes. We believe it is particularly important for investors that seek to achieve specific outcomes such as contributing to protecting the environment. 

Active ETFs provide another option in the investor toolkit. It is up to individuals to choose which is the best option for them or whether they prefer a combination of active and passive investments in both ETF and traditional mutual fund formats.

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