How ‘Active ETFs’ Are Shaking Up Passive Investing

Exchange-traded funds are simple, cheap and hugely popular. Their goal is to invest in or replicate the performance of a basket of assets or index. Rather than pay a money manager hefty fees to actively pick and choose what the fund holds, ETFs have been “passive” investments, automatically buying and selling based on the benchmark being tracked. Now a hybrid approach known as active ETFs that seek to keep the advantages of the format while outperforming benchmarks is gaining adherents, thanks in no small part to the success of Cathie Wood and Ark Investment Management. It remains to be seen if her peers can replicate her stunning returns or will simply repeat the fee-laden underperformance that has long dogged active management. Questions have been raised in particular about a breed of active ETF that lets managers keep their strategies under wraps.

1. What are active ETFs?

Like all ETFs, they offer investors part ownership of a pool of assets via shares that trade publicly on an exchange all day. Each also has a benchmark index, reflecting an investment strategy focused on a particular market sector or theme, like large cap companies or disruptive technologies. The difference in an active ETF is that a manager or team runs the fund -- they are actively trying to beat their benchmark, and they have discretion over what to buy and sell in order to do so. This means they can deviate from the benchmark as they see fit, for example by choosing to sell stocks that are under-performing and substitute new ones.

2. How does that work?

Take the ARK Innovation ETF (ticker ARKK), Cathie Wood’s flagship fund which contains Tesla Inc. as its largest holding. When shares of the automaker plunged in September after missing out on being included in the S&P 500 and on news of a partnership between competitors Nikola Corp. and General Motors Co., Wood took the opportunity to buy more shares at a lower cost. Since then, Tesla has risen about 140% and ARKK is up 83%.

3. What’s the attraction?

For those interested in beating the market and who believe strongly in a particular asset manager, team or strategy, active ETFs can help. ETFs are renowned for their liquidity and ease of trading, as well as for certain tax advantages. Active ETFs take these advantages and give the fund extra flexibility -- managers can react when market conditions are rapidly changing, such as during the coronavirus pandemic. The benefit to firms who choose to release actively-managed products is that those funds typically command a higher fee and therefore a larger profit. The average passive equity ETF charges 0.49%, while its active counterpart averages 0.72%.

4. How big is the trend?

Active funds still comprise a relatively small portion of the entire $5.9 trillion U.S. ETF industry. As of February, these funds contained about $205 billion, or less than 4% of the ETF market. But they’re growing rapidly, gaining about $55 billion in 2020 for their best year on record. The poster child for active ETF success is Wood at Ark, who runs five of the most popular active products on the market. Her stock-picking prowess -- all of her active funds generated triple-digit returns in the past year -- has helped her total ETF assets hit $60 billion. Meanwhile, fixed-income products such as the JPMorgan Ultra Short Income ETF (JPST) and the PIMCO Enhanced Short Maturity Active ETF (MINT) are proving popular with bond investors. Their managers have shown an ability to find attractively valued bonds and adjust their portfolios based on signals from the U.S. Federal Reserve regarding interest rate moves.

5. Are all active ETFs created equal?

No. After a rule change in late 2019, the newest product on the block is the ANT -- the active non-transparent ETF. These funds have lower disclosure requirements, meaning they provide less information about their holdings and investment approaches. That helps protect managers from having their strategy copied and from front running, the practice of making trades just ahead of someone else’s anticipated trade -- advantages that are hugely appealing for ETF issuers. There are several different structures under which this is allowed; a popular one requires issuers to publish their holdings once a quarter instead of daily, although they must calculate an indicative value of fund assets every second so that the ETF’s price can reflect their value. Firms including Fidelity Investments Inc., T. Rowe Price Group Inc. and Invesco Ltd. have all launched non-transparent offerings.

6. What are the downsides of an active ETF?

Although typically cheaper than equivalent mutual funds, there are worries that active funds are relatively pricey in the ETF world, and that investors may wind up paying more for performance that could as easily lag a benchmark as beat it. (Some managers might have dumped Tesla when it fell, for instance.) In fact, statistically, most active managers fail to beat their benchmarks -- which was a big part of passive investing’s appeal in the first place. In rare instances, there are worries about scale and diversification. For instance, some market watchers have raised fears that Cathie Wood’s future returns could be hurt by the unrelenting influx of cash into her products, since she’ll increasingly face concentration risk and may have to deploy cash into her next-best ideas. Meanwhile, the lower transparency of ANT funds has prompted concern that their portfolio holdings could deviate far from their benchmarks without investors being aware of the risks.

The Reference Shelf

  • A Bloomberg News article giving an overview of active ETFs.
  • A description of ANTs.
  • A QuickTake on the history and growing complexity of ETFs.
  • A look at how active ETFs can fill a gap in investing strategies.

©2021 Bloomberg L.P.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.