Actively managed ETFs summarized
Actively managed ETFs can offer investors flexibility to adapt to market changes, aiming for outperformance through research-driven strategies. Compared to passive ETFs, they provide greater control but come with higher fees and require careful manager selection. Combining active and passive approaches can help build resilient, diversified portfolios.
In this article:
What are active ETFs?
An active ETF is an exchange-traded fund that is managed by a portfolio manager(s) that uses research-driven opportunities for growth. This allows a manager to make strategic decisions aimed to outperform benchmarks or achieve specific outcomes.
An active ETF manager is able to leverage research, forecasts, and their own judgment to adapt the active ETF to changing market conditions. Active ETFs could also focus on particular strategies, such as value, quality or dividend paying securities- or a specific theme.
How does active management work?
It requires some management to address market considerations. Active investment management believes that markets can be inefficient, and that securities within those markets can be mispriced against their fair value.
Within an active ETF, a manager has flexibility in the portfolio construction process, allowing for the selection of securities or sectors that they believe have the potential to outperform, while avoiding securities or sectors that are overvalued or riskier.
Additionally, in periods of market weakness, a manager can pivot the portfolio through various means. An active ETF manager may increase cash holdings, for example, to avoid or lessen impact, versus investment in an index fund, which must stay true to the underlying index.
Can active ETFs beat the market?
They can potentially outperform the market by aiming to capitalize on market inefficiencies and quickly adapting to changing market conditions. Once an active strategy for the ETF has been determined, the portfolio manager has several tools and techniques available to help them decide which investments to hold, purchase, or sell, and how to diversify their investments.
These techniques can be broken down into the following 4 categories:
- Diversification: Active ETF managers have the flexibility to follow research data, meaning they are not required to hold specific stocks or bonds within the ETF. A manager can also over- or underweight sectors based on their research and can select securities from other markets, such as the U.S., Europe, or Asia.
- Fundamental analysis: A method of evaluating a security that examines related financial, economic, and qualitative factors that provide the intrinsic value, or the calculated true worth, of a security.
- Quantitative analysis: A method of evaluating the value of a security that examines data-driven models and alternate data sources. This type of analysis allows for the removal of behavioral biases.
- Risk management: Various methods of shielding against investment risk include hedging, volatility, targeting, and downside protection.
What are the limitations of actively managed ETFs?
These limitations of actively managed ETFs are primarily connected to:
- Higher fees compared with index funds, since active management relies on ongoing research and strategic decision-making.
- Risk of underperformance, as no actively managed ETF can guarantee better results than its passive benchmark.
- Dependence on skilled portfolio managers. Even experienced managers face periods of lower performance, and some strategies perform better in certain market environments than others. Choosing the right manager remains essential.
Where can I find actively managed ETFs?
Most self-directed investment platforms have an ETF Center where investors can use a screening tool to search for active or passive ETFs, as well as other criteria.
When viewing an ETF symbol in the quote section, pay close attention to the name: in most cases, a passively managed ETF will include the word “index” in the name of the ETF.
What are passive ETFs?
Passive ETFs aim to replicate the performance of a specific market index, such as the S&P 500 or MSCI World. Passive ETFs suggest there is little added value in trying to beat the market. Investors who accept this approach are looking to track a benchmark index—and the return that comes with it—minus the fees. The investor appeal of this type of investing is the simplicity and transparency of the ETF (you know what you are buying) and the cost efficiency (most of these ETFs are low cost ).
What are the limitations of passive (index) ETFs?
Although a popular choice, passive ETFs are not without limitations:
- Restricted potential for outperformance: Passive ETFs aim only to match market returns, not exceed them.
- Full exposure to market downturns is linked to the full investment of a passive ETF (very little cash holdings).
- Buy/sell decisions driven by index changes, not research: the investor accepts to invest in a process that follow mechanical rules (e.g. market-cap), based on index changes rather than fundamentals. For example, fixed income indices may overweight the most indebted issuers regardless of the ability to repay.
- Concentration risk: Major indices are often market cap weighted which often give much higher weight to large companies, while smaller holdings have minimal impact.
For example, in the S&P 500:
- the top 10% has a 62.8% weighting of the index, and
- the bottom 10% has a 0.7% weighting of the index.
Active and passive ETFs: A strategic approach to self-directed investing
Overall, active and passive investing strategies each have unique implications within portfolio construction. Even using a passive strategy can have an active component, leaving the active calls to the individual investors to decide which risk factors to be exposed, when to rebalance and when to reallocate. With active, you’re outsourcing at different level those active calls. It could be at the sector level, at asset class and even at the portfolio construction level, all depending on your needs.
Certain asset classes, sectors, and market environments are especially well-suited to active investment approaches, and by blending active investment with passive investment in line with your investing strategy, you can create a resilient portfolio strategy that responds well to opportunity and risk.
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Key Takeaways
- Passive ETF management offers simplicity and is low-cost, but exposes investors to market downturns and concentration risk.
- Active ETF management provides flexibility and potential for return outperformance but requires careful manager selection and comes with higher fees.
- Combining actively managed ETFs with passive, index-tracking ETFs can help investors build stronger and better diversified portfolios for evolving market conditions.