Active Everything: Is the ETF Industry Redefining Active Management?

Fixed Income ETFs: The Original Active-Passive Hybrid

Long before the explosion of actively managed equity ETFs, fixed income ETFs had already introduced active decision-making into a process marketed as passive. Replicating a broad bond index has always been far more challenging than replicating a simple equity benchmark.

Many bond indexes contain thousands of securities, many of which rarely trade. This forces fixed income portfolio managers to make active choices—selecting bonds based on liquidity, availability, and transaction cost rather than strict pro-rata index replication.

To facilitate this, issuers applied for custom basket relief from the SEC, giving them flexibility to substitute certain bonds in and out of the fund during creations and redemptions.

This flexibility is critical for maintaining liquidity and managing tracking error—but it also introduces subjective decision-making, a hallmark of active management.

The result? Even ETFs labeled as passive fixed income products often rely on active portfolio management techniques behind the scenes.

The Current Active Boom: Flexibility Over Alpha?

Fast forward to today, and the appeal of flexibility has extended far beyond fixed income. By labeling a fund "active," issuers gain the ability to:

• Avoid rigid index rebalancing schedules.
• Customize baskets to improve trading efficiency.
• Adjust holdings outside of formal reconstitution events.
• Reduce scrutiny around tracking error, since performance is no longer judged solely against a benchmark.

For some funds, this flexibility enables managers to pursue true alpha. But in many cases, "active" is less about high-conviction investment calls and more about operational freedom—a structural decision, not an investment strategy.

Case Study: Active in Name Only?

Consider the wave of thematic and income-focused active ETFs launched in 2024 and 2025. Many of these products closely resemble existing passive ETFs with nearly identical holdings.

The primary difference? Managers are allowed to tweak weights, add or remove securities, and adjust for liquidity—all useful tools, but hardly the discretionary stock picking most investors expect from an "active" product.

Even in covered call and options-based ETFs, the active label is often more about applying a defined overlay than making discretionary security selections.

These are rules-based strategies wrapped in an active label, raising the question: Are investors paying for true active management or just for flexibility?

The Market Maker’s View: Pricing Uncertainty—And the Role of Forward-Looking Baskets

For market makers and authorized participants (APs), the distinction between passive and active ETFs is critical. Passive ETFs follow a predictable playbook—baskets are disclosed in advance, rebalance schedules are known, and hedging models are straightforward.

Active ETFs, however, introduce new layers of uncertainty. Unlike their passive counterparts, custom baskets are the norm rather than the exception. This unpredictability forces market makers to dynamically adjust hedging strategies, often with less transparency.

In domestic equity ETFs, market makers typically hedge using the exact basket of securities that an ETF holds. When an active ETF provides a daily forward-looking basket, market makers must adjust their positions accordingly—not just for the day’s trading, but also in preparation for the next day’s rebalance.

For example, if an actively managed U.S. large-cap equity ETF announces changes to tomorrow’s basket—swapping out certain stocks and adjusting weightings—market makers must take a two-step approach:

1. Trade intraday to hedge against today’s known basket, ensuring they can facilitate creations and redemptions.
2. Rebalance at the close to align with the updated exposure for the following trading day.

The more frequently these rebalances occur, the greater the risk of trading costs, market impact, and slippage from executing the hedge. These costs inevitably get passed on to investors through wider bid-ask spreads, particularly in less liquid names or during periods of heightened volatility.

But what investors see on the screen doesn’t always tell the full story.

At times, screen markets may appear tight, with narrow bid-ask spreads. However, these quotes are often driven by high-frequency trading (HFT) firms posting small-size markets—100 shares at a time, sometimes even less. While these tight spreads create the illusion of deep liquidity, the reality changes when real size orders come into play.

When a large block trade needs to be executed, the increased complexities of active ETFs—frequent rebalances, shifting baskets, and unpredictable hedging costs—inevitably widen spreads in size markets. This means that while the screen may show a 1-cent or 2-cent spread, institutional investors looking to trade in meaningful size will often face a much wider, less liquid reality.

This distinction highlights a crucial point: while active ETFs provide issuers with flexibility, that same flexibility increases pricing complexity for market makers and APs. In fixed income, some issuers have historically worked with market makers and APs to mitigate uncertainty, whereas in equities, the regulatory framework necessitates a daily forward-looking disclosure to ensure more efficient trading and price formation.

However, the more frequent and unpredictable the basket changes, the greater the friction in market making—resulting in higher costs that ultimately impact end investors.

Investor Expectations: Time for a New Vocabulary?

Investors used to know what they were buying:

• Passive = Low cost, precise exposure.
• Active = Higher cost, with a chance for alpha.

Now, the meaning of "active" is increasingly murky. Many so-called active ETFs are really passive strategies with operational flexibility baked in. The risk is clear: Investors may be overpaying for products they assume will deliver manager skill, when in reality they’re buying a passive basket with some liquidity management sprinkled on top.

It may be time for the industry to develop a clearer vocabulary—perhaps distinguishing between:

• Rules-based active (operational flexibility with minimal discretion).
• Fully discretionary active (true high-conviction stock picking and tactical allocation).

Without clearer language, investor expectations will continue to drift out of sync with reality.

Conclusion: Back to First Principles

Having spent over 25 years in the industry as a market maker and capital markets expert, I can tell you this: True active management is valuable—but only if investors understand what they’re paying for.

Whether it’s a bond ETF quietly adjusting holdings to manage liquidity or a thematic fund shifting weights to optimize for flows, the line between active and passive has blurred. That’s not inherently a problem—unless investors are left in the dark.

In a world where "active everything" has become the default, transparency matters more than ever. It’s time to have an honest conversation about what "active" really means—and to ensure that label reflects reality, not just marketing convenience.  If "active" is to mean anything, it’s time for the industry to define it—before investors start questioning its value altogether.

About the Author

Nicholas Phillips | President of ETF Capital Markets Advisors LLC
With over 25 years of experience in ETF market making and capital markets, Nicholas Phillips is recognized as a subject matter expert in the ETF industry. He started his career spending the first ten years as a lead market maker for SIG and Goldman Sachs.

At the helm of MCAP LLC's ETF Desk, Nicholas built and scaled the division, enhancing its operations through innovative pricing and risk models, and robust relationships with market makers and issuers. His tenure at Van Eck Associates as Director of ETF Capital Markets further solidified his expertise, managing critical facets of operations and deepening connections within the trading community.

Beyond market making, Nicholas is an avid content creator, sharing insights that demystify complex market dynamics. He is keen on exploring board member roles that benefit from his extensive background and forward-thinking approach to ETF strategies. His dual US/Ireland citizenship complements his global perspective, enriching his professional endeavors in diverse markets.

Disclaimer

Please note that this article reflects the author's personal views and does not represent the opinions of the publication or its affiliates. It is for informational purposes only and does not constitute investment advice. It is essential to seek guidance from a registered financial professional before making any investment decisions.