An Exchange Traded Fund (ETF) is an investment vehicle that bundles a diversified portfolio of stocks and bonds, with shares sold on the stock exchange. 

While ETFs started as passive investment vehicles, there are many that are now actively managed — overseen by fund managers who choose stocks and/or bonds in an effort to achieve above-market returns. These managed funds are called actively managed ETFs or active ETFs.

How Do ETFs Work?

An ETF functions like a cross between a stock and a mutual fund. ETFs are traded on an exchange like a stock. Yet these funds are comprised of shares of many stocks and bonds, like a mutual fund. As such, an ETF is a low-cost and tax-efficient option to invest in a variety of asset classes and investment strategies. 

ETFs tend to have lower annual expenses than mutual funds, but due to the fact that they are traded like stocks, they come with higher transaction costs such as commissions, bid-ask spreads, and other fees. 

What Is an Active ETF?

Most ETFs are passively managed — they track an index such as the S&P 500 or the Nasdaq. But as ETFs have grown in popularity, more and more of them have become actively traded, meaning that the fund’s manager actively buys or sells stocks and/or bonds to try to beat the market and generate higher returns. 

Despite the growth of active ETFs, they are still quite a small part of the overall ETF market. There were more than 500 actively managed ETFs in the U.S. in 2021, which accounted for about $193 billion in assets under management. That may seem like a lot, but these comprise less than one-fifth of all U.S. ETFs and make up about 3.5% of the total dollar amount invested in ETFs. 

Why Are Active ETFs Surging? 

The market for ETFs has more than quadrupled in less than a decade, leaping from $1 trillion in 2010 to more than $4 trillion in 2019. In 2018 alone, institutions currently investing in ETFs bumped average allocations in these funds to 24.8% of total assets, a significant increase from 18.5% in 2017. This phenomenal growth is driven by enthusiasm among institutional investors: 78% of institutional investors prefer ETFs to other index vehicles, according to a 2019 study of ETFs by Greenwich Associates.

There are several catalysts behind this surge in active ETFs, including the following. 

No Minimum Costs

Active ETFs have a far lower barrier to entry than mutual funds, which is the other actively managed product people invest in. Actively managed ETFs do not require a minimum investment, unlike mutual funds, which typically demand an initial outlay that can run into the thousands of dollars. An investor can buy a single share or fraction of a share of an ETF, allowing them to add an actively managed investment to their portfolio for as little as $1. While it’s important to be alert to fees and commissions associated with ETFs, many brokerages now offer commission-free trading, which makes ETFs even more affordable and accessible.

Tax Advantages

ETFs are known for tax efficiency in contrast to traditional mutual funds. ETFs are often more tax-efficient because they are index funds, which have fairly low turnover and thus provide less chance to realize gains when stocks or bonds are sold. More importantly, ETFs have a particular structure that is even more central to their tax efficiency. Shares of ETFs are created and destroyed through in-kind transactions that take place between the fund’s sponsors and an organization called an authorized participant. Due to this set-up, ETFs don’t usually have to directly sell positions from their portfolios to meet redemptions and can in this way avoid taxable capital gains distributions.

Rapid Risk Management 

Volatility in world events and economic circumstances in the last few years has left traders with a taste for being able to easily and rapidly manage risk as things change. As investors seek to reposition their portfolios to address a variety of risks, ETFs are a good tool to actualize specific changes without undue hassle. Other characteristics of ETFs, such as execution speed, single-trade diversification, and liquidity, are also helpful in mitigating risk. 

Versatility 

Institutional investors continue applying ETFs to more and more portfolio functions. This is possible because these funds have phenomenal versatility and can be applied to a wide range of strategic and tactical goals. It helps their popularity that institutional investors tend to prefer ETFs for factor-based and other specialized exposures.

Downside Protection

Early in 2021, actively managed ETFs clocked in at $200 billion in combined assets under management. Investors continue to seek out high returns with robust downside protection in an economic environment that remains in turmoil. Active management can be a key to that downside protection, and active ETFs are an affordable and accessible option for investors. 

What Are Common Active ETF Applications? 

  1. Tactical adjustments: Strategically tweak a portfolio to increase or reduce exposure to certain styles, regions, or countries.
  2. Strategic allocation: Bolster a portfolio with a long-term strategic holding.
  3. Rebalancing: Reduce risk between rebalancing cycles.
  4. Portfolio management: Round out and balance strategic asset allocation.
  5. Global diversification: Get access to foreign markets.
  6. Cash flow management: Help maintain liquidity.
  7. Transition enablement: Enable smooth management transitions. 
  8. Risk reduction: Mitigate risk and hedge changes in allocation.

Pros and Cons of Active ETFs

Pros

  • Active ETFs do not have investment minimums, and thus have a low barrier to entry. 
  • Many brokerages offer commission-free trading, making ETFs affordable and accessible.

Cons

  • Active management does not necessarily translate to higher returns.
  • Active ETFs charge higher fees than passive ETFs regardless of performance.

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This blog is sponsored by Magnifi. The information and data are as of the June 21, 2021 (publish date) unless otherwise noted and subject to change. This material is provided for informational purposes only and should not be construed as individualized investment advice or an offer or solicitation to buy or sell securities tailored to your needs. This information covers investment and market activity, industry or sector trends, or other broad-based economic or market conditions and should not be construed as investment research or advice. Investors are urged to consult with their financial advisors before buying or selling any securities. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. Past performance is no guarantee of future results. This content may not be reproduced or distributed to any person in whole or in part without the prior written consent of Magnifi. [As a technology company, Magnifi provides access to tools and will be compensated for providing such access. Magnifi does not provide broker-dealer, custodian, investment advice or related investment services.]