The Ins and Outs of Active ETFs

Additional content provided by John Lohse, Senior Analyst, Research.

Active exchange-traded funds (ETFs) have become increasingly popular with investors in recent years, we believe due to their combination of active management and the inherent advantages of the ETF construct. In contrast to conventional passive ETFs that typically strive to mirror the returns of a particular index, active ETFs seek to employ the skill of active fund managers who use their expertise to choose investments they believe will beat a benchmark. Recent trends have seen active ETFs gain persistent net positive inflows relative to their active mutual fund counterparts. The chart below highlights the divergence in investor preference for active ETF vehicles as indicated by the number of domestic ETF launches. New active ETF launches overtook passive in 2020 and have been higher in the period from 2021 onwards. 

Active ETF and Active Mutual Fund Flows* (in millions $)

* U.S. active ETFs and Mutual Funds only
Source: LPL Research, Morningstar Direct 08/12/24

Improved Tax Efficiency 

Both active and passive ETFs offer the potential for increased tax efficiency compared to Mutual Funds. The mechanism through which ETFs can gain a tax advantage is the in-kind creation/redemption process. Selling securities at a gain by a mutual fund portfolio manager can create a capital gain payout that the investor bears. Those capital gains are passed onto shareholders of the fund, even if they themselves haven’t transacted shares of the mutual fund at a gain. ETFs, however, can avoid this through dealing in-kind with authorized participants (APs). When there is an imbalance in the supply and demand for a particular ETF on the primary market, shares can be created or redeemed with the AP in order to satisfy the marketplace. APs facilitate this process by buying or selling baskets of securities which the ETFs hold and transacting these baskets with the fund sponsor to create or redeem ETF shares. In this case, the ETF portfolio manager isn’t required to outrightly sell the underlying securities, in effect shielding them from excess capital gains. These processes work best for ETFs that invest in liquid sections of the market, such as large cap equities and short/intermediate treasury bonds. When analyzing the liquidity capacity of ETFs, it’s the liquidity of the underlying market that is more pertinent than the liquidity of the ETF itself. Bear in mind, there are cases in which ETFs will have to realize gains such as a portfolio rebalance, however, the wrapper structure and in-kind creation/redemption feature of the ETF vehicle will generally offer a more tax-advantaged product to the end investor.  

Active Management and Flexibility 

A potential difference between active ETFs over their passive counterparts is, as the name suggests, the active management element of their strategy. Being active enables fund managers to implement their best ideas, as they attempt to beat their benchmarks, rather than being strictly bound to an index replication strategy. Active management has the potential to generate alpha but also has the potential to underperform passive ETFs.  

Intraday Liquidity and Trading Flexibility 

Active ETFs provide the benefit of intraday liquidity, allowing investors to buy or sell shares throughout the trading day at market prices. This feature offers greater flexibility than Mutual Funds, which are typically priced only at the end of the trading day. This does, however, introduce a drawback to ETFs that mutual fund investors don’t have to contend with. Since ETFs are traded like stocks, the prices at which an investor can buy or sell are determined by market demand, not necessarily by the value of the underlying assets in the fund. This creates scenarios in which an ETF can be purchased above its Net Asset Value (NAV), or sold below its NAV. 

Cost-Effectiveness 

Active ETFs generally have lower expense ratios compared to actively managed Mutual Funds. The average fee for active ETFs is often lower than that of Mutual Funds, providing investors with more cost-advantaged options to active management. 

The Downside: Capacity Constraints 

The biggest drawback of active ETFs relative to Mutual Funds is their inability to close the fund to new investors. As investors pile money into popular or well-performing Mutual Funds the manager has the ability to close the fund to new money in order to preserve the market in which they invest from oversaturation. By doing so, managers who trade in illiquid segments, such as small cap equities, don’t have to invest new money into those stocks, thereby driving prices higher. This also allows mutual fund managers to stay nimble, affording them the option to exit positions in a timely and price-efficient manner. Navigating this will be a major challenge for active ETF managers that invest in more thinly traded securities and can potentially dilute the pool of suitable options for investors interested in certain market segments.  

Summary 

Active ETFs can combine the benefits of active management within an ETF structure, making them an appealing option for investors seeking to enhance their portfolios. With features such as tax-efficiency, flexibility, intraday liquidity, and cost-effectiveness, active ETFs may offer a compelling addition to the investment universe along with traditional Mutual Funds and passive ETFs. As the market for active ETFs continues to grow, evolve, and mature, we believe they may play an increasingly important role in portfolio construction.