How do active ETFs work: A guide for investors
As actively managed exchange-traded funds (ETFs) grow in popularity, it’s important for investors to be able to differentiate between active ETF strategies and to understand the ways in which active ETFs can be employed in portfolios.
The benefits of active ETFs
Active ETFs work by tapping into the research skills of professional portfolio managers, who look to exploit inefficiencies in stock or bond indices to boost risk-adjusted returns. Instead of just generating the market return (beta), an active ETF aims to deliver performance in excess of the benchmark (alpha) while maintaining the attributes of the ETF structure. With future market returns expected to be lower, this ability to generate alpha is likely to become a more important contributor to overall portfolio performance.
Active ETFs can also partly mitigate some of the limitations of market-cap indices, by deviating from benchmark weightings (within certain tracking error limits). Active fixed-income ETFs, for example, have the ability to assess the creditworthiness of individual issuers and deviate from the weighting methodology of traditional fixed income benchmarks, which give larger weightings to issuers with higher outstanding debts.
Finally, active strategies can provide efficient exposure to certain investment criteria, such as securities with strong environmental, social and governance (ESG) characteristics. Rather than simply excluding controversial sectors, active managers can consider sustainability in all investment decisions, through engagement with companies and through rigorous stock analysis.
Selecting an active ETF provider
Of course, investors should note that, in an active ETF, security selection, investment allocations and risk management will be based on the portfolio manager’s investment philosophy, conviction and skill. There can therefore be considerable scope for active ETFs to underperform if investment decisions are consistently wrong. It’s therefore vital that investors ensure that chosene active strategies are based on proven, repeatable processes that align with their risk tolerance and overall investment objectives.
As with passive ETFs, active ETF providers need to be backed by a dedicated capital markets team that can deliver efficient pricing at all times while utilising both primary and secondary markets to boost liquidity. However, because active ETFs have the flexibility to trade outside of their normal rebalancing period, it’s perhaps even more essential that the ETF provider has the requisite trading expertise and capital markets resources, as well as the technology support, to deliver these extra trading requirements, while also providing best execution and price transparency to investors.
Another major factor in the selection of an active ETF is price. As well as the total expense ratio, investors need to evaluate all the costs incurred for holding an ETF, which include such factors as transaction costs related to portfolio rebalancing, and any costs associated with securities lending. It’s also important to factor in the potential excess returns from active investing, which can have a large bearing on the total cost of ownership for an active ETF. Also when evaluating the cost of investing, investors should also include transaction fees charged by financial intermediaries.
Using active ETFs in an investment portfolio
In a lower return world, where investors need their money to work harder, a blend of active and passive ETFs can provide an attractive balance between risk and return. While they introduce higher index risk, many active ETF strategies are well suited to helping investors add alpha to portfolios 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.