As actively managed ETFs usage gather pace, we look at the similarities and differences to their passive peers in our ETFs Explained series. In this episode, we look at ways the two differ.
Structure
The term “active” in ETFs refers to specific investment decisions, which are designed to seek specific outcome opportunities, such as outperforming an index (alpha), generating potential income, or expressing an investment view in terms of duration, yield or credit quality. An active ETF provides access to these specific strategies, while at the same time maintaining the attributes of the ETF structure.
A passive ETF on the other hand typically tracks an index or benchmark such as the S&P 500 Index or Global Aggregate Bond Index and aims to perform in line with the index.
Investment expertise
Active ETFs seek to bring expert research and security selection to ETF investors. These vehicles are backed by insights from experienced portfolio managers and a team of research analysts. Such oversight and active security selection are aimed at identifying dislocations in the market and accessing available outperformance opportunities.
Passive ETFs establish a benchmark and invest in the securities that are in the benchmark.
Active ETFs are designed in a way that they can go beyond the limitations of market-cap indices that passive ETFs track. By simply tracking an index, passive ETF may likely invest in the bigger companies in an equity index and the bigger debt issuers in a bond index as they constitute a higher percentage in the index. On the contrary, active ETFs provide the flexibility to tap the entire equity and bond markets, opening up the potential for opportunities to manage risk and add alpha.
Risk Management
Active ETFs are structured in such a way that they can be nimble in volatile markets. Active security selection and portfolio manager expertise may clear the way to not just spot value opportunities but also potentially adjust to rapid market shifts. For example, in a market downturn, the fund manager can reallocate the underlying assets to a more defensive strategy.
Passive ETFs reallocate assets too but it is usually to mirror the periodic index rebalancing. This is because, passive ETFs aim to track the performance of the designated index as closely as possible. During index rebalancing, the constituent weights are reassigned or certain constituents are removed or added to ensure the composition of the index adequately reflect its stated methodology. Passive ETFs also follow the same method in reallocating underlying assets.
