From Tracking Error to Discretion: Where ETF Risk Now Lives

Where Structure Ends and Discretion Begins

Over the past decade, the ETF industry has undergone a significant shift. Passive funds, once the dominant force, are now being joined—and in many cases overshadowed—by a growing wave of active strategies. With that shift comes a fundamental change in how portfolio management risk is measured, monitored, and ultimately understood by investors.

In passive ETFs, the rules are clear. A benchmark defines the objective, tracking error measures success, and portfolio managers are often evaluated—and compensated—based on how closely they adhere to that mandate. Discipline is embedded in the structure. Boards review deviations, execution is scrutinized, and the goal is consistency and precision.

But in active ETFs, the framework is far less defined. There is no single index to replicate, no universally accepted measure of “tracking error,” and often no clear line between skill and outcome. Flexibility becomes discretion, and with that discretion comes a different kind of risk—one that is harder to observe, harder to quantify, and in some cases, easier to overlook.

In active ETFs, there is often still a benchmark, but it serves a very different purpose. Rather than defining the portfolio, it is typically an index selected by the issuer as a reference point, something the strategy is expected to outperform rather than replicate. That benchmark may not always be tightly correlated to the strategy itself, and in some cases, it may be selected with a degree of bias. It helps frame performance, but it does not define the process.

Structure vs. Discretion

To be clear, many portfolio managers and issuers are doing everything they can to deliver strong performance. The intent is there, the effort is there, and in many cases the expertise is there. But unlike passive ETFs—where rebalancing rules are defined and executed with precision—active strategies often operate with far more flexibility around when, how, and why changes are made.

That flexibility can be a strength, but it can also introduce inconsistency. Without a clearly defined structure governing rebalancing and execution, performance can begin to drift—not necessarily because decisions are wrong, but because the framework itself lacks discipline. In some cases, that structure may never have been fully established to begin with.

Which raises a fundamental question:
Does structure matter, or does performance alone tell the full story?

When Strategy Quietly Changes

One of the less discussed risks in active ETFs is not just how positions are traded—but how the strategy itself can evolve over time.

Consider an active growth-oriented ETF. At its core, the investor expects exposure to growth companies, with the understanding that there will be volatility along the way. That is the mandate they believe they are investing in.

But what happens when the portfolio manager makes a macro call?

In one instance, an active growth ETF significantly reduced its exposure to higher-growth, more volatile names during a period when the manager believed the market was entering a bubble. The portfolio was repositioned toward more stable, lower-volatility stocks for a period of time.

From a portfolio management perspective, that decision may have been entirely justified. It reflects discretion, experience, and an attempt to protect capital.

But from an investor’s perspective—particularly for those not monitoring holdings on a daily basis—the strategy they originally invested in had materially changed.

They believed they owned a growth strategy. For a period of time, they owned something very different.

That is a different kind of risk—one not captured by traditional measures like tracking error or volatility, but one that can meaningfully impact outcomes.

In passive ETFs, the mandate is defined and rarely deviates. In active ETFs, the mandate may be interpreted—and at times, redefined—in real time.

When Structure Was Predictable—and Priced In

Earlier in my career, I spent time on index desks—including a stint in Ireland with Susquehanna International Group—where a significant part of the job was anticipating index and fund rebalances. These events weren’t just operational—they were opportunities.

When a fund tracked an index with clearly defined rules, you could model what was coming. If a stock was being added, you could begin accumulating it ahead of the rebalance. If it was being removed, you could short it early. The larger the fund and the less liquid the underlying names, the more pronounced the opportunity.

This wasn’t guesswork—it was structure. The rules governing what went in and out of a portfolio were transparent, repeatable, and predictable. That predictability allowed market participants to position around flows and provide liquidity ahead of time.

From Opportunity to Efficiency

As more market participants began to recognize and anticipate these rebalance events, something interesting happened. The trades that were once viewed as opportunities gradually became more crowded. More desks, more capital, and more sophisticated models entered the space, all attempting to position ahead of the same flows.

And over time, that competition changed the outcome.

Rather than increasing volatility, in many cases it reduced it. Rebalances that were once expected to create sharp dislocations became more orderly. In some instances, the price action even moved in the opposite direction of what traders anticipated, as positioning became crowded and expectations were already priced in.

What emerged was a more efficient ecosystem. With more participants competing to provide liquidity around these events, the execution of large blocks improved. Spreads tightened, market impact diminished, and the end investor—whether they realized it or not—benefited from better overall execution.

Structure didn’t just create predictability—it invited competition. And competition, over time, improved outcomes.

What Happens Without Structure?

The question now is whether that same level of participation and efficiency can develop in a more discretionary environment.

Without clearly defined rules and timing, it becomes harder for market participants to anticipate flows—and harder for that same competitive dynamic to take hold. Rebalances in active strategies are often less transparent, less predictable, and more dependent on individual decision-making.

That doesn’t mean they are wrong. But it does mean they are harder for the market to prepare for—and harder for investors to evaluate.

Liquidity, Execution, and the Hidden Decisions in Passive

Even in passive ETFs—where structure and discipline are core to the process—portfolio management is not always as mechanical as it may appear.

Rebalances are often associated with a single event, typically executed at the close using a Market-on-Close (MOC) order. But in reality, that is not always the case. When liquidity is limited—particularly in smaller or less liquid names—executing the entire rebalance in one session can introduce significant market impact.

As a result, portfolio managers may choose to spread that rebalance over multiple days, and in some cases, over the course of a week. This introduces a trade-off: minimizing market impact versus maintaining tight tracking to the index.

That trade-off is, in itself, a form of portfolio management risk.

Over time, the industry has learned from these challenges. Liquidity considerations are now far more integrated into the rebalance process, and execution strategies have evolved to balance efficiency with accuracy. But importantly, these decisions are still made within a defined framework—one where tracking error is measured, monitored, and ultimately held accountable.

Structure doesn’t eliminate decision-making—it defines how those decisions are evaluated.

Which leads to a natural question:

If liquidity risk and execution decisions exist even within structured, passive strategies—how are they evaluated in active ETFs, where tracking error is no longer the anchor?

Without that benchmark-driven discipline, the incentive to optimize execution relative to a defined standard becomes less clear. Liquidity may still be considered—but how consistently, and against what measure of success?

In passive funds, these decisions are made within guardrails. In active funds, those guardrails are often replaced by discretion.

Where Risk Becomes Harder to See

In passive ETFs, risk is visible. Tracking error tells you how closely a fund is doing its job. Deviations are measurable, explainable, and monitored.

In active ETFs, risk is different. It can take the form of:

• Timing decisions
• Execution quality
• Strategy drift
• Liquidity mismatches
• Turnover and trading costs

These risks are real, but they are not always transparent. Investors often see the outcome—performance—but not the process that produced it.

Two ETFs can show similar performance over a given period—but arrive there in very different ways.

One follows a defined process, with predictable rebalances that allow the market to compete and provide efficient execution. The other relies on discretion—deciding when to trade, how to trade, and how aggressively to move.

The outcome may look the same.

But the risk taken to get there—and the ability to evaluate that risk—is very different.

Leveraged and Complex Products: Risk Amplified

This dynamic becomes even more pronounced in leveraged and more complex ETF structures.

Products that rebalance daily—particularly leveraged ETFs—can experience performance decay in volatile markets due to the mechanics of compounding and rebalancing. These outcomes are not always intuitive, and in many cases, investors may not fully understand how or why performance diverges from expectations over time.

The risk in these products isn’t just directional—it’s structural.

The People Who See It in Real Time

Interestingly, the group that often has the clearest view into this risk isn’t the investor—it’s the market maker.

Market makers evaluate baskets daily. They price risk in real time, manage inventory, hedge exposures, and immediately see whether value was gained or lost through execution. Every rebalance, every trade, every adjustment is reflected in their P&L.

They see the cost of decisions as they happen.

Investors, by contrast, typically see periodic performance—daily NAVs, monthly returns, quarterly reports. The underlying drivers of that performance are often less visible.

The Visibility Gap

As the ETF industry continues its shift toward active management, the nature of portfolio management risk is changing.

It hasn’t disappeared. It hasn’t diminished.

But it may be becoming harder to see.

In a world where passive funds are judged by precision, active funds are often judged by outcome. And while outcomes matter, they don’t always tell the full story.

The real question for investors is not just how a fund performed—but how that performance was achieved, and whether the process behind it is repeatable, disciplined, and understood.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.