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Exchange-traded funds, or ETFs, are one of the most popular investments because of their low costs, diversification benefits and liquidity. Most ETFs are passive, meaning they track an index such as the S&P 500 or Nasdaq Composite. But actively managed ETFs have emerged on the investment scene in recent years and have captured investor interest.
Here’s what you need to know about active ETFs.
What is an actively managed ETF?
Active ETFs are managed by professional investors in an attempt to outperform a market index such as the S&P 500. A portfolio manager and a team of research analysts work to identify investments that they believe will perform better or worse than the overall market, and then position the fund’s prices. portfolio accordingly.
Historically, actively managed funds have mostly consisted of mutual funds, but active ETFs have grown in recent years, attracting a record $131 billion in annual assets by 2023, according to Morningstar. ETFs have certain advantages over mutual funds, such as tax efficiency and trading liquidity.
One of the reasons active ETFs have been slow to catch on until recently was the requirement that ETFs disclose their holdings daily. Fund managers did not want to reveal their investment strategies just so that other traders or investors could benefit from their work. But in 2019, the Securities and Exchange Commission passed a new rule allowing semi-transparent ETFs. These semi-transparent ETFs did not have to disclose their entire holdings on a daily basis, paving the way for more active ETFs.
Pros and cons of actively managed ETFs
Benefits of active ETFs
- Potential to perform better: The main benefit of investing in active ETFs is their potential outperformance. A talented portfolio manager may be able to add value over time by selecting the right investments, but as with any investment, there is no guarantee that this will happen.
- Intraday Liquidity: ETFs provide intraday or intraday liquidity because they trade on an exchange similar to the way stocks are traded. Mutual funds, on the other hand, can only be bought and sold at the end of each trading day at the fund’s net asset value, or NAV.
- Tax efficiency: ETFs can be more tax efficient than mutual funds because of the way shares are bought and sold. When mutual funds are redeemed, the fund may have to sell certain investments to meet the redemption, which could create a tax liability for continuing fund shareholders. ETFs are only taxable if you sell the fund for a profit.
- Cheaper than comparable investment funds: Active ETFs typically have lower expense ratios than actively managed mutual funds.
Disadvantages of active ETFs
- May lag behind passive ETFs: While the goal of active ETFs is to outperform the overall market, in reality that may not happen. In fact, studies have shown that the vast majority of active managers fail to outperform a passively managed fund over time.
- Higher costs than passive ETFs: You will pay higher fees for active ETFs because of the portfolio manager and research team trying to identify superior investments for the fund. These costs may be justified if the fund outperforms, but if the fund underperforms, you have an underperforming investment for which you paid more in fees – possibly more for less.
- Unlimited fund capacity: Unlike mutual funds, ETFs cannot close their doors to new investors, which can pose challenges for funds with certain investment strategies. For example, a fund that focuses on small-cap companies may reach a size where it is too big to buy small-cap stocks, upending its strategy.
In short
Active ETFs are a way to combine the tax efficiency and intraday trading of ETFs with the potential for outperformance that comes with an actively managed fund. To be fair, there is no guarantee that active ETFs will outperform a passive alternative. The funds will also incur higher costs than funds that track broad market indices such as the S&P 500.
