What Are Active ETFs and How Do They Work?

An Exchange Traded Fund (ETF) is an investment fund traded on stock exchanges, much like individual stocks. These funds hold a diversified collection of underlying assets, which can include stocks, bonds, or commodities. While many ETFs track the performance of a specific market index, a distinct category exists where the fund’s holdings are actively managed.

The Core Concept of Active ETFs

Active management within an ETF means a dedicated fund manager or team makes ongoing decisions about the fund’s portfolio. Unlike passive ETFs that merely replicate a benchmark index, active ETFs empower these professionals to select specific securities. Their objective is to outperform a chosen benchmark or achieve a defined investment goal through their choices. This process involves continuous research and analysis of market conditions, economic trends, and individual securities. Managers buy, sell, or hold investments based on their outlook and the fund’s strategy, aiming to capitalize on opportunities or mitigate risks.

Operational Differences from Passive ETFs

Passive ETFs mirror the performance of a specific market index, such as the S&P 500, by holding the same securities in similar proportions. In contrast, active ETFs rely on the expertise of a fund manager who makes independent decisions regarding security selection and asset allocation, aiming to generate returns that exceed an index.

Portfolio turnover differs significantly between these two types of funds. Active ETFs often engage in more frequent buying and selling of securities as managers adjust the portfolio based on market views or investment theses. Passive ETFs have lower turnover, rebalancing their holdings periodically to maintain alignment with their tracked index.

Expense ratios, which represent the annual fees charged to investors, are higher for active ETFs. This reflects the costs associated with professional management, research, and frequent trading. For instance, while a passive ETF might have an expense ratio below 0.10%, an active ETF could have an expense ratio ranging from 0.50% to over 1.00% annually. Transparency regarding portfolio holdings can also vary, as some active ETFs utilize non-transparent or semi-transparent structures to protect their proprietary trading strategies from being easily replicated by competitors.

Important Investment Considerations

Higher expense ratios in active ETFs directly impact an investor’s net returns over time. These management fees are deducted from the fund’s assets annually, regardless of whether the fund achieves its performance objectives. Over many years, even small differences in expense ratios can accumulate, significantly reducing the total wealth an investor retains.

The expertise and consistency of the fund manager are important for an active ETF’s potential success. The fund’s performance depends heavily on the manager’s skill in identifying undervalued securities, making timely investment decisions, and navigating market cycles. Investors should examine the manager’s track record, investment philosophy, and tenure to understand the stability and effectiveness of the management approach. A change in management or a shift in strategy could alter the fund’s performance trajectory.

Tax efficiency is another consideration for active ETFs due to their higher portfolio turnover. When a fund sells securities for a profit, it can generate capital gains. These gains are distributed to shareholders annually and are subject to taxation for investors holding the ETF in a taxable brokerage account. Long-term capital gains are taxed at rates like 0%, 15%, or 20% for individuals, depending on income, while short-term capital gains are taxed at ordinary income tax rates, which can be as high as 37% for the highest earners. Passive ETFs, with lower turnover, distribute fewer capital gains, offering greater tax efficiency.

Active ETFs trade on exchanges, similar to individual stocks, throughout the trading day. Their liquidity, or the ease with which shares can be bought and sold without significantly impacting the price, is influenced by several factors. This includes the liquidity of the underlying securities held within the fund and the activity of market makers, who facilitate trading by providing bids and offers. Investors should be aware that less liquid underlying holdings or lower trading volume in the ETF itself could lead to wider bid-ask spreads, affecting the execution price of trades.