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Active ETF – Basics
Active ETFs are growing in popularity in Europe. As one of the fastest-growing segments in asset management, they appeal to private and institutional investors alike. But what exactly are active ETFs, and how do they work?
This page aims to answer the most frequently asked questions about active ETFs.
What is an active ETF?
ETF stands for Exchange Traded Fund which means that it is a product traded on an exchange regardless of its investment strategy. In short, the ETF is simply a wrapper and the content itself is independent of the vehicle.
An active ETF is an exchange-traded fund where the portfolio manager actively selects securities with the goal of outperforming a benchmark, unlike passive ETFs that track an index (an active investment strategy in an ETF wrapper).
How do they differ from a mutual fund or passive ETF?
What are the key differences between active ETFs and smart beta ETFs?
Management Style
Active ETFs are actively managed by portfolio managers who select and adjust holdings to seek to outperform a benchmark. In contrast, smart beta ETFs are semi-active strategies to enhance their benchmarks by tilting it towards factors like value and growth, or by changing its weighting scheme.
Tracking Error
Smart beta ETFs exhibit only a small to moderate tracking error, as they are still tied to an index, while active ETFs have a higher tracking error due to the discretionary decisions.
Fees
The rules-based approach of smart beta ETFs requires less human intervention and, therefore, usually charges lower fees than those of active ETFs.
What are the benefits of an active ETF?
Access to Manager Expertise
Investors gain access to insights, experience and decision-making of investment professionals, which can potentially lead to outperformance.
Flexibility
Portfolio managers can actively adjust and select the fund’s holdings in real time based on market conditions, enabling them to respond quickly to emerging opportunities or risks.
Cost efficiency
Cost are generally more advantageous than mutual funds due to lower management and distribution fees.
Intraday trading
Active ETFs offer real-time pricing and liquidity. They are traded like stocks.
Transparency
Most active ETFs disclose their holdings daily, which allows an easy monitoring and risk assessment by investors. Daily disclosure to market makers is necessary and allows better pricing and tighter spreads.
Active risk management
Active ETFs provide the advantage of a dynamic risk management, as portfolio managers can adjust the fund’s exposure to mitigate the risk compared to passive ETFs which track a designated index.
ESG
Passive ETFs are tracking an underlying index, therefore the ESG integration depends on this underlying index, whereas with the active management of active ETFs or mutual funds, portfolio managers apply and adjust tailored ESG criteria in real time based on controversies or regulatory changes.
Tax advantages
ETFs domiciled in Ireland may offer tax advantages. Investors should consult their tax advisor for further details.
What are the risks of an active ETF?
Risks of an active ETF are similar to the risks of an active mutual fund and may be exposed to the following risks:
Discretionary management risk
The performance and success of an active ETF depend on the skills and expertise of the portfolio manager. Poor decision-making on their part could lead to underperformance.
Cluster/concentration risk
A portfolio manager might choose to concentrate investments into a smaller number of securities or sectors, which could lead to amplified losses due to reduced diversification.
Liquidity
An active ETF’s liquidity primarily depends on its underlying assets. Depending on the assets held by an active ETF, it might face challenges selling these assets in times of distress in the market. Furthermore, market makers are required to facilitate the trading of an ETF’s shares. Thus, reduced market maker activity will lead to a reduction of the liquidity of an active ETF.
Other risks may apply, such as equity risk, interest rate risk or credit risk.
What role can an active ETF play in a portfolio?
For investors, active ETFs can serve multiple roles within an allocation: as core holdings with an active tilt, as satellite strategies for specific themes or market segments, or as tactical tools to respond swiftly to changing market conditions.
Investors searching for active strategies but who like the convenience offered by the ETF structure, might appreciate active ETFs. Data shows that investors are increasingly using active ETFs to replace or complement passive strategies.
Which criteria should an investor consider when searching for an active ETF to invest in?
Before investing in an active ETF, it is essential that investors consult the regulatory documents (KID, prospectus), in particular to familiarise themselves with the characteristics of the fund and understand the management strategy, as well as the due diligence procedures applied, the investment horizon and the risk profile. Passive ETF due diligence teams focus on aspects like liquidity, spreads and tax benefits. Active mutual fund due diligence teams focus on the investment strategy, historic results and investment capabilities. As active ETFs combine the features of ETFs and active investment strategies, investors should consider both sides in their analysis.