What Is an Active ETF and How Does It Work?
Demystify Active ETFs. Learn about their unique structure, how they're managed, and what sets them apart in the investment landscape.
Exchange-Traded Funds (ETFs) are investment funds that trade on stock exchanges, similar to individual stocks. Investors can buy and sell shares throughout the trading day at market prices. An active ETF is managed with the goal of potentially outperforming a benchmark or achieving a defined investment objective through strategic decision-making.
How Active ETFs Operate
An actively managed ETF operates under the guidance of a dedicated portfolio manager or management team. This team continuously makes investment decisions, buying and selling securities within the fund’s portfolio. The manager’s role involves ongoing research and analysis of market activity, economic conditions, and specific assets to inform these decisions. Their objective is to adjust the portfolio’s holdings to align with the fund’s investment goals, which often include outperforming a chosen benchmark.
This discretionary approach means the portfolio can be adjusted based on the manager’s market outlook, rather than being tied to a fixed set of rules. This allows for dynamic security selection and market timing. Investment professionals utilize their expertise to navigate changing market conditions.
Distinguishing Active from Passive ETFs
A fundamental difference between active and passive ETFs lies in their management philosophy. Active ETFs employ a discretionary approach, with managers aiming to outperform a specific benchmark through strategic trading and security selection. In contrast, passive ETFs are designed to replicate the performance of an underlying market index, such as the S&P 500, by holding the same securities in similar proportions.
Regarding portfolio construction, active ETF portfolios are dynamic, adapting holdings more frequently based on manager decisions and market assessments. Passive ETF portfolios, however, are typically fixed to the components of their tracked index and only rebalance periodically according to the index’s predetermined rules.
The primary investment objective also distinguishes these two types of funds. Active ETFs seek to generate returns that exceed a benchmark, often referred to as “alpha.” Passive ETFs, conversely, aim simply to mirror the performance of their chosen index, providing market exposure at a generally lower cost.
Key Attributes of Active ETFs
Active ETFs have higher expense ratios compared to their passive counterparts. This is because the costs associated with in-depth research, more frequent trading, and the expertise of a portfolio management team are factored into the fund’s operational expenses. While the average passive ETF expense ratio might be around 0.07% to 0.11%, active ETFs can have an average fee ranging from 0.65% to 0.76%.
Transparency levels in active ETFs can vary. Many traditional active ETFs provide daily disclosure of their portfolio holdings, similar to passive ETFs. Some active ETFs, however, utilize non-transparent or semi-transparent structures. This approach aims to protect the fund’s proprietary trading strategies from being replicated by other market participants.
Active management inherently carries the potential for both outperformance and underperformance relative to a benchmark. The goal of an active ETF is to achieve returns greater than its benchmark. However, the fund may underperform its benchmark, especially after accounting for the higher fees associated with active management.