How to handle active exchange-traded funds

According to Kaylie Pferten, active exchange-traded funds (ETFs) offer a number of benefits over other types of open-ended investment vehicles

If you have ever invested in an exchange-traded fund (ETF), it was probably a passive investment. An ETF, instead of actively attempting to outperform a specific stock market index, tracks it up and down. Because of how long these vehicles have invested, the terms "ETF" and "passive" are now practically interchangeable. But that is now changing.

Only 234 new passive ETFs were introduced by fund managers in the first half of the year, compared to 476 actively managed ETFs in the US and Europe, according to new data from financial data provider Morningstar Direct. In the US and Europe, only £1.02 trillion is held in active funds, while £13 trillion of assets are still managed by passive ETFs. In contrast to the 39% increase in passive ETF assets since the end of 2023, the latter number has more than doubled.

Senior investment analyst Alex Watts of the investment platform Interactive Investor says, "Active ETFs have garnered a lot of attention and launches are becoming more commonplace across Europe." "Although the assets under management in traditional passive ETFs still far outnumber those in active ETFs, the number of active ETFs has increased in the US, where the wrapper for active strategies has been adopted more quickly.

What is causing the active ETF trend?

Priorities first. It's critical to keep in mind that an ETF is not a stand-alone investment. Instead, it serves as a structure or a shell for a portfolio of underlying assets. Similar to alternative investment structures like unit trusts, open-ended investment companies (Oeics), and investment trusts, exchange-traded funds (ETFs) allow investors to pool their funds into a single fund, which is then managed by a professional manager using the funds' mandate. It could be a directive to invest in common stocks in the US or the UK or something more obscure.

This year marks the 35th anniversary of ETFs, which have long been linked to passive investing. The first exchange-traded funds (ETFs) were created in reaction to the 1987 global stock market crash, which is one reason for this. According to analysts, market sell-offs might not have occurred as sharply if a larger group of investors had held diverse equity portfolios. The goal of early exchange-traded funds (ETFs), such as the well-known SandP 500 SPDR, was to facilitate this broader ownership by using funds that tracked the entire stock market.

Additionally, the idea that ETFs are only passive vehicles has been reinforced by the fact that the ETF industry has grown during a time when many investors have abandoned active management. Low-cost index trackers are now the preferred option for investors who have grown weary of costly active funds that don't outperform the market. Managers of ETFs have complied with that request.

In actuality, though, there is nothing about an ETF's structure that restricts it to passive investing. Active ETFs function in precisely the same manner as any other collective fund with the objective of outperforming the market in which it makes investments. In accordance with their theories about what will lead to outperformance, the manager purchases and sells holdings. According to Morningstar data, this is a rapidly expanding ETF market subsector. Although more managers are joining them, the largest names in active ETFs at the moment are JPMorgan, Amundi, Fidelity, and BlackRock. This year, Jupiter and Lazard both introduced their first active ETFs. Not far behind them is Aviva Investors.

According to Tom Bailey, head of research at HANetf, a specialized ETF company, this trend is being driven by the benefits of the ETF structure. "Whether they're looking for an active or passive investment strategy, investors want the ETF wrapper," Bailey says. "The benefits of ETFs are becoming more widely recognized.

Advantages of active exchange-traded funds.

Investors who purchase ETFs, in particular, benefit from significantly greater price transparency. Real-time pricing information is provided to investors regarding the cost of investing in an exchange-traded fund (ETF) that is listed on a stock market. On the other hand, investors usually don't know exactly how much they're paying for mutual funds like unit trusts and Oeics until after the transaction has concluded because they are priced at the end of each trading day. Customers aren't expected to agree to buy many products without knowing the precise price at the time of purchase, according to Bailey.

There is a tax benefit associated with many European ETFs. A treaty between the two nations allows the majority of these funds, which have their domicile in Ireland, to pay a lower withholding tax on dividends from US sharestypically 15% as opposed to 30%. This tax efficiency has the potential to significantly alter returns over time, particularly for ETFs that have a significant amount of exposure to US stocks.

A more technical justification for active ETFs is provided. Investors can more easily hold managers accountable when ETFs are listed on a stock exchange, according to the Bank for International Settlements (BIS). ETF shares, for instance, can be sold short. In contrast to mutual funds, the BIS found that this results in greater discipline, with ETF managers more likely to be fired after a period of poor performance. That should, in principle, result in higher long-term returns. There are, of course, no guarantees. Ben Yearsley, a director of the wealth-management company Fairview Investing, states that "the ultimate success or failure of an ETF is down to the skill of the manager picking the stocks," just like with other kinds of active funds.

What are the drawbacks of active ETFs?

It should be mentioned that there are some drawbacks to the ETF structure. The fact that these funds are open-ended means that when investors buy or sell, the manager may issue new shares or cancel existing ones, which could lead to issues with their stock market listings. ETFs only work well when they are used to hold highly liquid asset classes, like bonds and common stocks. A closed-ended investment trust is typically a better choice for investors seeking exposure to other asset classes, such as private equity, real estate, or illiquid infrastructure.

Cost is another issue. Since they are inexpensive to operate, passive ETFs have frequently competed on the basis of extremely low fees. Actively managed funds, on the other hand, demand a lot of resources, from the manager to expensive research. "The cheaper end of the Oeic market and investment trusts are usually priced similarly to active ETFs," Yearsley continues.

Due to the discrepancy between perception and actual costs, this could impede the long-term growth of active ETFs. To put it another way, even if they are truly receiving more value for their money, investors who have historically viewed ETFs as inexpensive may object to being asked to pay more.

However, ETF specialists anticipate that more managers will broaden the range of active funds they offer. "Offering strategies across multiple wrappers, such as investment trusts, ETFs, and Oeics, makes sense for fund houses," says Bailey. "It makes sense to meet investors where they are as they grow more accustomed to the ETF wrapper, especially younger investors.

Moreover, regulatory reform is beneficial. The way stock-market-listed funds are regulated has historically been one of the factors working against the use of ETFs for active investment strategies. Up until recently, funds that were listed on open stock exchanges had to release daily detailed reports of their whole portfolios. That posed a challenge for active managers looking to beat their rivals or increase their holdings in new businesses. However, in 2019, US regulators relaxed disclosure requirements, and other countriessuch as Ireland and Luxembourgfollowed suit, which has helped with this problem.

With managers disclosing copious amounts of information about their holdings, ETFs continue to be more transparent than other kinds of collective vehicles. In fact, a lot of investors in these vehicles are drawn to this as well. However, active managers' worries about this kind of wrapper have subsided since they are no longer obliged to offer a running commentary on every facet of their investment strategy.

Determining what active means at a specific fund is one important question. Watts writes, "A straightforward definition is an exchange-traded fund (ETF) where a manager is making investment decisions to outperform a given benchmark, rather than just replicate the return from it."

Knowing about active ETFs.

There are undoubtedly different takes on the theme. Certain active exchange-traded funds (ETFs) are active in the conventional sense of the word, with managers conducting unrestricted investment procedures. Others are far more constrained, depending on computer-driven tactics that deviate only slightly from benchmark indices.

These funds, which are often less expensive but not active in the traditional sense, are sometimes referred to as "shy active" or "benchmark-aware" exchange-traded funds. If investors comprehend the funds' mandate, that is not an issue; however, the performance of such an ETF is unlikely to diverge substantially from the benchmark.

As always with investing, it's important to know what you're getting. The belief that active investment strategies can be worthwhile is largely reflected in the trend towards active ETFs. You can outperform the market, even when asset prices are declining and an active strategy might be able to provide some protection, if you can find a reliable manager.

Since more and more managers are now offering nearly identical funds under multiple different wrappers, if you believe that argument, you will then need to decide which structure is best for accessing active management. According to Watts, there is a compelling argument for the ETF structure. Compared to buying mutual funds, which typically takes longer and have non-continuous pricing, active exchange-traded funds (ETFs) offer investors the convenience of trading and real-time pricing throughout the day.