Active ETFs: Five myths debunked
Demand for exchange-traded funds (ETFs) has grown rapidly across the globe in recent years. While much of this growth has been driven by passive funds, research shows that investors are increasingly looking at active ETF strategies. Nevertheless, there are still lots of common misconceptions that are hindering the take-up of active ETFs. Here, we debunk the most common active ETF myths.
Myth 1: Active management and ETFs don’t mix because ETFs are passive by definition
ETF just means exchange-traded fund. This means ETFs can be traded on an exchange regardless of whether they are active or passive. In essence, an ETF is just a wrapper and there are a variety of strategies that can be used to leverage the benefits of the ETF structure. “Active” refers to a portfolio management strategy where the manager makes specific investment decisions with the goal of outperforming an investment index or achieving a specific outcome. Instead of just tracking an index and 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.
Myth 2: Active ETFs are not relevant outside of the US market
Investors are increasingly realizing that the ETF wrapper could also be an ideal home for actively managed strategies. Active ETFs have already seen quite impressive growth in the US – and other regions could follow this trend: 71% of European investors and 79% of Greater China investors recently said they expect their exposure to active ETFs will increase over the next 12 months1. We expect active ETFs to be one of the factors that will drive further ETF growth, providing investors with the opportunity to earn alpha – return - on their investments while still enjoying the benefits that they expect from the ETF vehicle.
1 Source: Brown Brothers Herriman 2022 Global ETF Survey
Myth 3: Active ETFs are expensive
Total expense ratios (TERs) for passive ETFs vary and can range from below 0.10% to above 0.60% (financial intermediary charges transaction fees). Usually, core investments, such as global equities, are cheaper than more complex strategies, such as thematic ETFs. In general, the price points of active ETFs are pretty similar to passive, notwithstanding the financial intermediaries’ fees, but outside of the core developed market exposures, active ETF TERs can actually be at the same level or even cheaper than those of their passive counterparts.
Myth 4: Active ETFs are less liquid and more expensive to trade
As with passive ETFs, a good active ETF will be backed by a dedicated capital markets team with a strong technology platform and strong relationships with a diversified set of authorized participants (APs). The ETF provider must be able to demonstrate that they can provide APs with all the information they need to deliver efficient pricing of the ETF at all times, while utilizing both primary and secondary markets to boost liquidity. If this is the case, trading active ETFs in terms of liquidity and price is not different to passive ETFs.
Myth 5: Active ETFs do not make good core investments.
Many investors use passive ETFs as core investments. We believe active ETF strategies are particularly well suited to helping investors build out the strategic core of their portfolios. The addition of active ETFs could provide several benefits, including diversification of products and ETF providers, and enhancement of the passive core performance by adding alpha opportunities. Ultimately, active ETFs offer investors access to long-term alpha - or excess return - potential, while benefiting from the attributes of the ETF wrapper.
Diversification does not guarantee positive returns or eliminates risks of loss.
Why choose active ETFs?
While investors are still subject to the same broad risks as in any market-based investment, and the value of investments can fall as well as rise, an active equity ETF does provide the chance to access excess returns above a chosen index.
Because the weighting methodology in active strategies is at the discretion of the portfolio manager (within certain tracking error constraints), some active ETFs can also partly mitigate the limitations of market-cap indices, which are biased towards the top performing equities and the most indebted bond issuers. They can also help provide a more rigorous exposure to certain investment themes, such as environmental, social and governance (ESG) factors.
Before investing in an active ETF, investors should conduct due diligence in much the same way as they would with a passive ETF. However, because 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 investment strategy. Ideally, the active strategy will be based on a, repeatable process that aligns with investors’ risk tolerance and overall investment objectives, and will also have a history of delivering investment expertise and insights.