October 12, 2020
Most exchange-traded funds (ETFs) are passively managed vehicles that track an underlying index. But about 2% of the funds in the $3.9 billion ETF industry are actively managed.
Actively managed ETFs offer many of the advantages of mutual funds but with the convenience of ETFs. Buying active ETFs is a great way to include active management strategies in your investment portfolio.
How Do Actively Managed ETFs Work?
As the name suggests, the fund managers who run actively managed ETFs pick stocks and make frequent trades to generate returns. Active ETFs contain hundreds—or even thousands—of securities, providing a similar level of diversification that investors expect from other ETFs and mutual funds.
The shares of actively managed ETFs are traded on major stock exchanges throughout the day, unlike mutual funds, which only trade once a day, after markets close. In addition, they provide more transparency into their holdings than actively managed mutual funds.
Semi-Transparent ETFs and Non-Transparent ETFs
Active ETFs are required to reveal all of their holdings each day. For the vast majority of passively managed ETFs, which track a public index, this kind of requirement is beside the point because their component securities are already public knowledge.
The requirement to disclose holdings is why there have been so few actively managed ETFs over the years, according to Kip Meadows, founder and CEO of Nottingham, which offers actively managed ETFs. Actively managed mutual funds don’t have the same reporting requirements.
“One reason active ETFs haven’t been as prominent is that the assets must be shared every night,” Meadows says. “When you’re a fund manager who has done all the research, you don’t want to disclose that to the world. You don’t want to give away the secret sauce.”
The Securities and Exchange Commission (SEC) has permitted less transparency for certain actively managed ETFs, which are referred to as semi-transparent ETFs or non-transparent ETFs.
“It can be called non-transparent because we’re not releasing everything we have in it,” says Greg Friedman, head of ETF Management and Strategy at Fidelity. “And it’s semi-transparent because you can see some of what’s available. But really, both terms refer to the same type of ETF.”
Friedman feels that the SEC designed the new rules to provide some degree of transparency to investors while also allowing active ETF fund managers to maintain their proprietary formulas and protect their research.
Index ETFs vs Active ETFs
While index ETFs and actively managed ETFs share certain design similarities, they employ very different investing strategies.
Index ETFs Are Passive Investing Vehicles
Index ETFs aim to match the performance of a benchmark index. Active ETFs generally try to beat the performance of a benchmark index.
As passive investing vehicles, the holdings of index ETFs depend almost entirely on the performance of an underlying market index. Fund managers buy and sell assets to track the index and duplicate its performance.
Active ETFs use market indexes as benchmarks. Rather than attempting to track or duplicate the performance of a given index, they try to beat its performance. If the fund manager of an active ETF plays their cards right, they may earn investors higher returns, although outperforming an index over the long term is very challenging.
Index ETFs Have Lower Costs
One big advantage of index ETFs are their lower expense ratios. While it can make sense to pay a higher expense ratio if you’re targeting a fund with a particular strategy, index funds tend to offer higher average returns over the long term, with lower average costs.
According to ETF.com, actively managed ETFs charge an average expense ratio of 0.69%. Equity index ETFs, on the other hand, charge an average expense ratio of 0.18%, according to the Investment Company Institute.
While a difference of about 0.50% may seem trivial, over decades it can cost you tens of thousands of dollars more. For example, if you invested $6,000 a year for 30 years and saw 6% average annual returns, an active ETF charging the average fee above would cost you roughly $44,000 more than the average equity index ETF.
Active ETFs Respond to Current Events
A big advantage of actively managed ETFs is their ability to respond to rapidly changing markets.
“Index funds are based on the status quo while the economy and the way we work are changing rapidly right now,” says Meadows. “It could be a year or more before some companies are dropped from an index and the changes reflected in an index ETF.”
Active portfolio managers change up their holdings as often as necessary, which means they can rapidly swap out companies that are seeing their share prices crushed by current events. This kind of agile response may be appealing to some investors.
Index Funds Offer Stable Long-Term Returns
Over the past 15 years, more than 87% of actively managed funds have lagged their benchmarks, according S&P Global. During that same period, which included the Great Recession, the S&P 500 has seen average annual returns of 8.9% with dividends reinvested.
Even in 2020, a year marked by unpredictability and economic uncertainty, actively managed funds have trailed benchmark performance, according to Berlinda Liu, director of Global Research & Design at S&P Dow Jones Indices.
That said, not all actively managed ETFs seek to outperform benchmarks—some simply aim to provide positive returns of some kind, regardless of overall market conditions.
Mutual Funds vs Actively Managed ETFs
Actively managed ETFs function similarly to actively managed mutual funds. Both are likely to see more compositional turnover than their indexed counterparts, and fund managers play a key role in choosing holdings. There are a few key differences between them, however.
Actively Managed ETFs Trade Like Stocks
Active ETFs trade like stocks. They can be bought and sold as frequently as needed, throughout the trading day. Mutual funds, on the other hand, only trade once a day as markets are closing.
This discrepancy may matter little for investors looking to add a bit of active management to their investments. Managers of both types of actively managed funds are responding in real time to market events, and investors buy a given fund to benefit from its longer-term investing strategy.
Actively managed ETFs’ stock-like tradability is relevant for another reason: If you plan to buy an actively managed fund in a margin account, you’ll need to stick with active ETFs. In most cases, you can’t buy mutual funds on margin.
Actively Managed ETFs Offer Better Tax Efficiency
One of the biggest advantages of an actively managed ETF is its tax efficiency. Because your money goes to buy what are known as creation units, instead of fund assets themselves, ETFs experience fewer taxable events than mutual funds.
“Mutual funds distribute gains immediately because the assets in a mutual fund are actually bought and sold,” Meadows says. “You’ll have to pay capital gains taxes, and it might be at the short-term rate—and could be high—depending on how often the securities are traded in and out of the fund.”
In contrast, you only realize capital gains when you sell your ETF shares. This distinction may be less relevant for those who hold active funds in retirement accounts, like 401(k) or Individual retirement accounts (IRAs). But investors who invest in their taxable brokerage accounts might benefit from the tax advantages of active ETFs.
Actively Managed ETFs Have Lower Investment Minimums
Depending on the broker, you might have to meet a high investment minimum to buy shares of a mutual fund. These minimums can be in the thousands of dollars, which may delay your ability to buy into a fund. ETFs in general lack investment minimums, so you may be able to get started investing in an active fund sooner or with less initial buy-in.
Mutual Funds Offer Less Transparency
Even with the new rules put in place by the SEC to allow less transparency in actively managed ETFs, Friedman says, mutual funds are still the less transparent investment vehicle.
“Actively managed ETFs still have to disclose their tracking baskets more often,” Friedman says. “Mutual funds might only disclose their holdings once a quarter and don’t have to share as much information.”
If fund transparency is important to you, then you might opt for shares of actively managed ETFs over actively managed mutual funds.
Should You Buy Actively Managed ETFs?
Whether you should add actively managed ETFs to your portfolio depends on your financial goals and risk tolerance.
If you’re simply looking to optimize for long-term returns, you might be best served by passive index funds. But if you’re looking to add active funds to your portfolio, for whatever reason, ETFs offer a few advantages over active mutual funds, though they may suffer from the level of transparency they’re forced to provide.
To determine how different investment types can work best for you, consider speaking with a financial advisor.