Demand for exchange-traded funds (ETFs) has grown rapidly in recent years. While much of this growth has been driven by passive funds, data shows nearly three out of four ETF investors plan to increase their exposure to active ETF strategies in the next two to three years1.
Nevertheless, there are several common misconceptions when it comes to actively managed ETFs. In the first in a series of write-ups, we debunk the myth: “Active ETFs are riskier than passive ETFs”.
Are active ETFs really riskier?
The level of risk largely depends on the underlying investments and is not based on whether an ETF is passively or actively managed.
Like any strategy, active ETFs have their own advantages. Given they are managed by professional investment managers, active ETFs have the flexibility to adjust allocation based on their own research, market conditions and economic trends.
The active ETF market has increasingly become as diverse as the active mutual fund market. They span various asset classes and strategies, including research enhanced indexing, unconstrained, and thematic strategies. Some active ETFs can also partly mitigate the limitations of market-cap indices that passive ETFs track. Under a market-cap index approach, the biggest companies in an equity index and biggest debt issuers in a bond index have more influence than smaller ones because they constitute a higher percentage in the index. On the contrary, actively managed ETFs provide the flexibility to tap the entire equity and bond markets, opening up the potential for unearthing opportunities to diversify risk and add alpha.
Are active ETFs less liquid and more expensive to trade?
Fundamentally, the liquidity profile of any ETF is driven by its underlying securities. The primary market costs of similar active and passive market exposures shouldn’t have significant differences, as they incur very similar commissions, taxes, and other charges.
Both active and passive ETFs, are typically backed by a dedicated capital markets team with a strong technology platform and relationships with a diversified set of market makers such as trading firms and investment banks. These market makers form their own view of the net asset value of the ETF and provide bids and offers in the market. A tighter bid-ask spread means more liquidity.
How can investors mitigate manager risk?
Active ETFs do not track a designated index. Instead, they are managed by professional investment managers and this in turn can give rise to potential behavioural biases that can impact investment decisions. Still, a thorough screening of the managers can help mitigate the risk. Investors can ideally pick an active strategy backed by a repeatable process that aligns with their risk tolerance and overall investment objectives.
Actioning ETF investing
As illustrated above, active ETFs are no more riskier than passive ETFs. However, investors should conduct due diligence in much the same way as they would with a passive ETF. As the benchmark is only a reference for active ETFs, and return generation can be very different, investors will need to pay close attention to the risk-reward profile of an investment strategy.