What is an exchange-traded fund?
Exchange traded funds are funds traded on an exchange just like a share. Like mutual funds, ETFs invest in a basket of securities, such as equities and/or bonds. Traditionally, they have aimed to mirror, rather than outperform, certain indexes - these funds are known as passive ETFs. ETFs, unlike traditional investment funds, can be traded in real time and typically charge lower management fees.
The rise of active ETFs
As noted above, most ETFs are passively managed, aiming to replicate the performance of the index they track. By contrast, decisions about the investments in an actively managed ETF are made by a portfolio management team, which may deviate from the index to meet the fund’s objectives.
The management team leverages proprietary research to generate insights into companies, sectors and macro factors, such as the direction of interest rates. They then adjust the fund’s investment strategy to attempt to outperform the index and/or define the portfolio to achieve the investment objective.
Demand for active ETFs is growing rapidly, with global assets under management in active ETFs reaching a record high of $889bn in May 2024. [1]
Potential advantages of active ETFs
Actively managed ETFs typically have higher operating costs than passive ETFs but lower expense ratios than traditional actively managed funds.
The manager is able to adapt to changing market conditions and can therefore potentially outperform the market. For example, if the ETF tracks a defensively weighted index, managers could deliver outperformance by tilting the fund towards more growth-oriented investments during periods when risk appetite is strong. Conversely, if the manager expects macro conditions to deteriorate, he can adopt a more defensive posture than the underlying index.
“One of the key advantages of actively managed ETFs is that they provide the manager the flexibility to deviate from the index, adapting to changing market conditions and capturing new investment opportunities. They also allow investors to access the manager’s expertise and research capabilities in trying to achieve outperformance."
yassar ali, global head of product strategy
… and the drawbacks
There is a risk that the active manager’s strategy could prove wrong, and the ETF will underperform the index. Actively managed ETFs are also typically not exact substitutes for actively managed funds because they are usually less active and have more controls on the liquidity of the underlying. This is because they need to account for the liquidity of the underlying to ensure tradability and have to keep management costs to a minimum, limiting the number of trades, they are likely to undertake.