Guide to Active ETFs

Though the ETF wrapper was initially developed in order to bring passive strategies to the markets in a highly liquid and tax-efficient way, more and more active ETFs have been issued in the years since. Active ETFs bring an investment manager or management team’s expertise and discretion to the security selection process, offering the potential to outperform their designated benchmark. This guide to active ETFs will cover how these types of ETFs differ from their passive counterparts, the differences between transparent and the newer generation of semitransparent (or nontransparent) ETFs, and the unique benefits and risks of active ETFs.

Active ETFs vs. passive ETFs

In 1993, the first ETF ever listed in the U.S. was launched. Still active today, the SPDR S&P 500 ETF Trust (SPY) is designed to track the performance of the S&P 500 index. Following this launch, many more index-tracking (or passive) ETFs were brought to market, initially tracking large-cap indices before expanding to cover other asset classes such as fixed income, REITs, and commodities. The goal of these index ETFs is to track the performance of a specified index, less expenses.

It was not until 2008 that the first active ETF was launched, offering a product that was based on the discretion of the investment manager or management team. Active ETFs are often designed to outperform a certain index or area of the market. Compared to passive ETFs’ goal of replicating index return, the portfolio manager can deviate from the index with the goal of adding alpha, outperforming the benchmark over time.

How do active ETFs work?

While passive ETFs have an underlying methodology or set of rules they follow to achieve their goal of tracking the index, active ETFs do not follow the same process. Instead, the portfolio manager or management team relies on their own research and decision-making process to build the portfolio’s allocation.

Some active ETFs are designed to be replacements for passive core ETFs, offering marketlike exposure with specified constraints around how much a certain sector or holding can deviate from the benchmark. Other active ETFs have fewer constraints, giving the portfolio management team more discretion over holdings and allowing for portfolios and performance that can look significantly different from the benchmark. 

For passive and active ETFs alike, investors should make sure they understand the rules and constraints underlying the ETF’s portfolio construction process as this can have a significant impact on the fund’s performance.

What are semi-transparent ETFs and active non-transparent ETFs?

In 2019, the SEC approved the first model that would allow active managers to offer ETFs within a semitransparent (also referred to as nontransparent) structure. This means that the investment manager is not required to disclose their holdings daily. Instead, the ETFs only periodically disclose holdings – for example, once a quarter.

What are the benefits and risks of active ETFs?

Active ETFs come with their own set of benefits and risks. Given their ability to deviate from the composition of the index, active ETFs offer the potential for alpha or outperformance of the benchmark. For example, an active manager can tactically tilt the portfolio towards certain sectors based on their economic outlook in the near term and dynamically shifting as the market environment changes. And compared to active mutual funds, the ETF wrapper allows these strategies to be offered at a cheaper price with higher levels of liquidity and tax efficiency.

However, this deviation from the index portfolio also creates the potential for the ETF to underperform the benchmark. Though these ETFs tend to be cheaper than their mutual fund counterparts, active ETFs tend to be more expensive than index ETFs – another factor that plays into their higher levels of tracking error and potentially eating into returns. 

Whether used on their own or in conjunction with index-tracking ETFs, active ETFs can have a place in investor portfolios as long as these benefits and risks are well understood.