Active ETFs: A guide for investors
Demand for exchange-traded funds (ETFs) has grown rapidly in Europe in recent years. This growth is now being further boosted by the development of more sophisticated smart beta and active strategies.
What are Active ETFs?
In essence, an ETF is just a vehicle and there are a variety of "engines" or strategies that can be placed in the structure to leverage its benefits. Similar to cars: combustion engines are the past and electrical engines are seen as the solution for the future. An active fund refers to a portfolio management strategy where the manager makes specific investment decisions with the goal of outperforming an investment benchmark or index. Instead of just generating the market return ("beta"), an active ETF aims to deliver performance in excess of the benchmark ("alpha") whilst maintaining the attributes of the ETF structure.
The active Advantage
While passive strategies continue to dominate flows into European ETFs, fund providers are increasingly realising that the ETF wrapper is also an ideal home for actively managed strategies. Active ETFs are one of the factors that will drive further ETF growth, providing investors with the opportunity to earn alpha on their investments while still benefiting from all the benefits that they expect from the ETF vehicle.
The benefits of active ETFs
An active equity ETF can provide access to excess returns above a chosen index, driven by fundamental stock selection. Because the weighting methodology in active strategies is at the discretion of the portfolio manager (within certain tracking error constraints), some active ETFs can partly mitigate some of the limitations of market-cap indices.
Active fixed income ETFs 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. Active strategies can also be used to gain exposure to certain investment criteria, such as securities with strong environmental, social and governance characteristics.
Due diligence for active ETFs: pay attention at the engine level
Before investing in an active ETF, investors need to conduct due diligence at the ETF wrapper level, 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 engine” to ensure their chosen strategy meets their investment needs. In an active ETF, stock selection, investment allocations and risk management will be based on a portfolio manager’s investment philosophy, conviction and skill. It’s therefore vital that investors ensure the active strategy is based on a proven, repeatable process that aligns with their risk tolerance and overall investment objectives.
Know your ETF provider
As with passive investments, when evaluating potential active ETF investments, 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 proven history of delivering investment expertise and insights.
Active ETF trading: what makes a good active ETF?
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 authorised 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 utilising both primary and secondary markets to boost liquidity.
Using active ETFs in an investment portfolio: strategic building blocks
ETFs provide a powerful portfolio construction tool for investors. Today, advanced strategies, such as active equity and corporate fixed income or smart beta fixed income, multi-factor strategic beta and ultra-short income are allowing investors to build ETF portfolios with a level of sophistication and diversification that they couldn’t have envisaged even just five or 10 years ago.
More efficient asset allocation
Active ETF strategies are particularly 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. Ultimately, active ETFs offer investors access to long-term alpha potential, while benefiting from the attributes of the ETF wrapper.
The future is active: Learn here more about our trading expertise and the benefits of active ETFs to choose the right strategy for investment.