How to approach active ETFs

If you’ve ever put cash into an exchange-traded fund (ETF), it is likely to have been a passive investment: a fund that tracks a particular stock market index up and down, rather than actively trying to beat it. These vehicles have invested this way for so long that the terms “ETF” and “passive” have become almost synonymous. Now, however, that is changing.

New data from financial-data service Morningstar Direct reveals that fund managers launched 476 actively managed ETFs in Europe and the US during the first half of the year, and only 234 new passive ones. Passive ETFs still account for $13 trillion of assets under management in the US and Europe, with only $1.2 trillion held in active funds. But the latter figure has more than doubled since the end of 2023, against 39% growth of passive ETF assets.

“Active ETFs have generated a lot of attention and launches are becoming more commonplace across Europe,” says Alex Watts, senior investment analyst at the investment platform Interactive Investor. “In the US, where adoption of the wrapper for active strategies has been quicker, there are now a greater number of active ETFs than conventional passive ETFs, although assets under management in the latter still far surpass the former.”

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What's driving the active ETF trend?

First things first. It’s important to remember that an ETF is not an investment in its own right. Rather, it’s a structure or wrapper for holding a portfolio of underlying assets. Like alternative structures such as unit trusts, open-ended investment companies (Oeics) and investment trusts, ETFs enable investors to pool their money in a single fund; a professional manager then invests that money according to the fund’s mandate. That might be anything from a directive to invest in mainstream UK or US equities to something more esoteric.

ETFs turn 35 this year and have always been associated with passive investment. That’s partly because the first ETFs were developed in response to the global stock market crash of 1987. Analysts reasoned that market sell-offs might not have been so pronounced if a wider range of investors had owned diversified portfolios of equities; early ETFs, including the very popular S&P 500 SPDR, aimed to enable that broader ownership through funds that tracked the whole of the stock market.

The fact that the ETF industry has developed during a period when many investors have turned their backs on active management has also fuelled the notion that ETFs are purely passive vehicles. Investors who have grown wary of expensive active funds that fail to beat the market have turned to low-cost index trackers instead. ETF managers have responded to that demand.

In practice, however, there is nothing about the structure of an ETF that limits it to passive investment. Active ETFs operate in exactly the same way as any other collective fund that has a goal of beating the market in which it invests. The manager buys and sells holdings according to their views about what will drive outperformance. As Morningstar’s data underlines, this is a fast-growing sub-sector of the ETF market. The biggest names in active ETFs currently include JPMorgan, Amundi, Fidelity and BlackRock, but more managers are joining them. Jupiter and Lazard have both launched their first active ETFs this year. Aviva Investors is not far behind them.

It’s the advantages of the ETF structure that is driving this trend argues Tom Bailey, head of research at HANetf, the specialist ETF business. “The ETF wrapper is what investors want, whether they’re looking for a passive or an active investment strategy,” Bailey says. “Awareness of the benefits of ETFs continues to grow.”

Benefits of active ETFs

In particular, investors buying ETFs get much more transparency on price. The price of a stock market-listed ETF is available in real time, with investors given upfront information about what they’ll need to pay to get into the fund. By contrast, mutual funds such as unit trusts and Oeics are priced at the end of each trading day; investors won’t typically know exactly what they’re paying for the fund until after the transaction has competed. “There aren’t many products where customers are expected to agree to buy without knowing the exact price at the time of purchase,” says Bailey.

With many European ETFs, there’s also a tax benefit. Most of these funds are domiciled in Ireland, enabling them to pay lower withholding tax on dividends from US shares – typically 15% instead of 30% – through a treaty between these two countries. Over time, this tax efficiency can make a real difference to returns, especially for ETFs with a great deal of US equity exposure.

Another argument for active ETFs is a more technical one. The Bank for International Settlements (BIS) notes that the fact that ETFs are listed on a stock exchange makes it easier for investors to hold managers to account. For example, it is possible to sell ETF shares short. That leads to increased discipline compared with mutual funds, the BIS concluded, with ETF managers more likely to be forced out following a period of underperformance. In theory, that should lead to better long-term returns. Naturally, there are no guarantees. “As with other types of active funds, the ultimate success or failure of an ETF is down to the skill of the manager picking the stocks,” says Ben Yearsley, a director of wealth-management firm Fairview Investing.

Do active ETFs have any downsides?

It should also be pointed out that the ETF structure comes with certain downsides. These funds are open-ended – meaning the manager creates new shares or cancels them as investors buy or sell – which can cause problems in the context of their stock market listings. ETFs only function effectively when used to hold very liquid asset classes, such as mainstream equities and bonds. For investors looking for exposure to other asset classes, such as illiquid infrastructure, property or private equity, say, a close-ended investment trust will usually be a better option.

There’s also the question of cost. Passive ETFs are cheap to run and have often competed on the basis of ultra-low charges. Actively managed funds, by contrast, require significant resources, from costly research to the manager themselves. “Active ETFs are typically priced similarly to investment trusts and the cheaper end of the Oeic market,” adds Yearsley.

“This may hinder the long-term growth of active ETFs, because there is a mismatch between perception and reality on costs.” In other words, investors who have always thought of ETFs as cheap may baulk at being asked to pay more, even if they’re actually getting more for their money.

Nevertheless, ETF experts expect more managers to expand their active fund ranges. “For fund houses, it makes sense to offer strategies across multiple wrappers – Oeics, investment trusts and ETFs,” says Bailey. “As the ETF wrapper becomes more familiar, particularly with younger investors, the logic of meeting the investor where they are is clear.”

Regulatory reform is also helping. Traditionally, one factor militating against the use of ETFs for active investment strategies has been the way that stock-market-listed funds are regulated. Until recently, funds listed on public stock exchanges were required to publish full details of their entire portfolios on a daily basis. For active managers seeking to outperform their competitors or to build up positions in new holdings, that was problematic. However, US regulators eased the rules on disclosure in 2019 – with other jurisdictions, including Ireland and Luxembourg, subsequently following suit – which has helped with this issue.

ETFs remain more transparent than other types of collective vehicle, with managers publishing extensive data on their holdings. Indeed, this is another attraction for many investors in these vehicles. However, active managers are no longer required to provide a running commentary on every aspect of their investment strategy, easing their concerns about this type of wrapper.

One key question is what active means at a particular fund. “[A] simple definition is an ETF where a manager is making investment decisions in order to outperform a given benchmark, rather than just replicate the return from it,” points out Watts.

Understanding active ETFs

There are certainly variations on the theme. Some active ETFs are active in the traditional meaning of the word, with managers running unconstrained investment processes. Others are much more limited, relying on computer-driven strategies that move away from benchmark indices to a minimal extent.

Sometimes described as “shy active” or “benchmark-aware” ETFs, these funds tend to be cheaper, but aren’t active in the conventional sense. That’s not a problem, if investors understand the fund’s mandate, but the performance of such an ETF is unlikely to deviate significantly from the benchmark.

The key, as always in investment, is to understand what you’re buying. In large part, the trend towards active ETFs represents a view that active investment strategies can be worth paying for. Assuming you can identify a good manager, you’re accessing the potential to outperform the market – including at times when asset prices are falling, when an active strategy may be able to offer some protection.

If you buy that argument, there is then a decision to make about the best structure for accessing active management, particularly as growing numbers of managers now offer near identical funds under several different wrappers. Watts believes there is a clear case to be made for the ETF structure. “Active ETFs are an exciting development for investors given the ease of trading and live pricing throughout the day versus a generally slower process of purchasing mutual funds with non-continuous pricing.”

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