ETFs: The Future is Active
Discover the active future of ETFs. Learn about our trading expertise and the benefits of active ETFs so you can choose the right strategy for investment.
Active exchange-traded funds (ETFs) are allowing investors to build portfolios with a level of sophistication and diversification that they couldn’t have envisaged even just five or 10 years ago. As demand for active strategies grows, it’s important for investors to have a full understanding of how they work compared to passive funds, and how they can be employed in portfolios.
Five things to consider when investing in active ETFs
As with passive ETFs, investors in active ETFs need to evaluate the capabilities of the ETF provider, the structure of the ETF and the cost of investing. However, with active ETFs raising additional questions about liquidity and pricing, investors will also need to take a close look at the ETF investment engine and the trading abilities of the ETF provider.
1. Select an ETF provider that you value
When evaluating potential active ETFs, investors should consider the character and capabilities of the ETF provider. Investors should choose to invest with a provider they value, and that has a similar history of delivering investment expertise and insights.
2. Evaluate the total cost of ownership
As with passive ETFs, the full cost of investing needs to be carefully evaluated when choosing an active ETF. As well as the total expense ratio (TER), investors need to evaluate other costs incurred for holding an ETF, such as transaction costs related to portfolio rebalancing, trading costs and creation/redemption costs. While the costs and risks associated with physical and synthetic (swap-based) index replication may be less relevant for active ETF investors, structural costs may still be relevant. For example, active ETFs may participate in security lending schemes to offset costs, similar to many physical replication passive ETFs.
3. Understand the ETF investment engine
While active strategies strive to deliver potential excess returns over and above the benchmark return, the range of possible outcomes and performance deviations from traditional benchmarks will be much greater than with passive ETFs. It’s therefore vital that investors ensure the active strategy is based on a similar, repeatable process that aligns with their risk tolerance and overall investment objectives.
4. Look at the liquidity of underlying securities
A good active ETF will maintain exposure to liquid and tradeable underlying securities, which will allow the cost of creating and redeeming shares to be low, and the ability to provide intra-day pricing to be high. Investors will also need to look at the fund’s portfolio construction to get a full view of its liquidity profile. This means analysing the investment criteria used to select securities, the risk management tools that the strategy uses, any tracking error considerations that are in place, and any individual security restrictions or other portfolio constraints that will influence the makeup of the portfolio.
5. Focus on trading expertise
Because active strategies have the flexibility to trade outside of their normal rebalancing period, investors should ensure that the ETF provider has the requisite capital markets resources and technology support needed to deliver these extra trading requirements. It’s also crucial to assess the ETF’s ability to access the secondary market—if an ETF suffers a redemption, or receives inflows, it may not need to trade its underlying securities. Consolidated trading reports, which show the level of hidden over-the-counter (OTC) trading as well as exchange-based trading, can help give a better view of an ETF’s secondary markets access.
Using active ETFs in an investment portfolio
Active ETF strategies are well suited to helping investors build out the strategic core of their portfolios. At the same time, an active strategy can be used to add alpha to a portfolio with core passive holdings, or to allocate tactically at different times through the market cycle.
For example, active fixed income ETFs can use sector and security selection to maintain a very similar duration and credit exposure over time, making them ideal for investors looking to quickly and efficiently change their yield curve positioning or sensitivity to credit spreads. Other examples include adding alpha to a plain vanilla portfolio, or using a growth-style ETF to reduce a portfolio’s value bias at relatively low cost.