Everything you need to know about a new kind of ETF

The pros and cons of 'active ETFs,' which fans say combine the best of actively managed mutual funds and index funds.

  • By Michael A. Pollock,
  • The Wall Street Journal
  • Investing in ETFs
  • Investing in ETFs
  • Investing in ETFs
  • Investing in ETFs
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There is a new exchange-traded fund in town, and it could have advantages over older funds.

Actively managed ETFs, available in increasing numbers from a range of investment companies, combine the most desirable features of actively managed mutual funds and index funds. They charge lower management fees than most actively managed mutual funds and trade through the day, like other ETFs. But, unlike traditional ETFs, they follow a focused objective other than tracking an index. Their portfolios can change daily as their managers buy and sell securities to take advantage of market moves.

Investors who want to take advantage of a particular strategy or manager thus can place bets that their active ETF will outperform the market or related benchmark, and at costs below those of traditional mutual funds.

Actively managed ETFs first appeared about 10 years ago, but with an insignificant amount of assets. Now, Morningstar lists 263 ETFs as actively managed. These have $66 billion in total assets, albeit a small corner of the more than $3.6 trillion ETF market in the U.S. The bulk of ETF assets are in fixed-income funds.

More than 60 firms offer them, including such household names as Franklin Templeton, State Street, Fidelity Investments, J.P. Morgan, BlackRock’s iShares unit, WisdomTree, Pimco and Vanguard. Advisers have been pushing some firms that offer popular traditional mutual funds to clone them in active ETF versions, which can save perhaps a half percentage point or more on fees while giving the adviser an easily traded, transparent and more tax-efficient strategy to use for clients.

But actively managed ETFs also are more complex than their predecessors. With other ETFs, the portfolio changes little and infrequently, so it’s easier to anticipate what you are investing in over time. In an actively managed ETF, by contrast, the manager or managers can change the portfolio on any given day. So, over time, investors in a fund may be surprised to see the portfolio start to look different from when they bought it. This is particularly an issue in equities, because managers of stock funds are paranoid about telling investors what they are doing for fear that a competitor will copy it.

Here are things investors need to understand about active ETFs before plunging in.

1. What exactly are actively managed ETFs?

They are a third generation of ETFs. The earliest ETFs sought to match the returns of a market index by owning a basket of securities similar to the index. The second wave, “smart beta” funds, aimed to beat, rather than match, the broad market by tweaking instead of mirroring index holdings—owning only stocks of companies in the relevant index that consistently boost dividends, for example.

Next came actively managed ETFs, which also try to beat the broad market. Instead of relying only on an alternative weighting, they hand over some of the responsibility for doing that to a manager or managers. There can be many. Northern Trust’s FlexShares Ready Access Variable Income Fund (RAVI), a conservative income-generating active ETF, bases its portfolio on Northern Trust’s views of the economy and rates as an institution, says strategist Abdur Nimeri.

It can be frustrating for an investor looking for actively managed ETFs to find one easily, since few bill themselves as “active” in their names. The websites of some fund firms may clarify whether certain ETFs are active, in terms of how they label the categories of funds they have. Beyond that, investors may need to either call the firm and ask, or look at the description of the fund on the website. If the description states that an ETF doesn’t closely follow an index or benchmark, it’s probably active.

“Investors deserve choices,” says Todd Rosenbluth, who heads ETF and fund research at data provider CFRA. “Now they have more.”

2. Where will I see them?

Most investor money in actively managed ETFs so far has flowed into fixed income. Among some of the more popular strategies in this sector are funds that focus on very-short-maturity bonds, aimed at investors who want more income than they could get from a money-market fund. Pimco Enhanced Short Maturity Active ETF (MINT), with $10 billion in assets, is one of the largest of these. It aims to beat the average money-market mutual fund’s performance by holding “a hodgepodge” of short-term, investment-grade debt securities, Pimco says.

Active ETFs in equities are less common so far, largely because of a regulatory requirement that ETF portfolios must be disclosed daily, thus scaring off managers who don’t want their strategies exposed. But more actively managed equities ETFs have been appearing. In February, Vanguard launched six, including one that targets momentum stocks—or those with strong recent performance—and a multifactor fund focuses on stocks of various cap size that score highly on the basis of attractive valuation, momentum and quality.

Some newcomers offer outlier strategies. San Francisco-based EquBot in June offered its AI Powered International Equity ETF (AIIQ), which invests in non-U.S. developed markets. It uses IBM ’s Watson supercomputer and artificial intelligence to sort through millions of public filings, news releases and social-media posts to find those with the best capital-appreciation prospects. The firm was established in early 2017 by a group of business-school students at the University of California at Berkeley.

3. Will I see them in my 401(k)?

Not yet, and probably not soon.

Companies that sponsor 401(k) plans typically are cautious about adding newer strategies to menus of funds available to participants because of concerns about pushing up administrative costs and because of the perceived risk of including strategies that haven’t been thoroughly time-tested. Many active ETFs are less than three years old.

4. Why would I want to buy them?

Anyone who likes active management and owns mutual funds could trim portfolio expenses by adding active ETFs. While mutual funds often charge more than one full percentage point a year of assets in management fees, many active ETFs charge around 0.3 to 0.7 point.

Active ETFs provide access to specialized and uncommon strategies. ARK Innovation ETF (ARKK) focuses on companies that disrupt markets with new technologies, such as 3-D printing and gene therapy.

Another outlier is Vanguard U.S. Liquidity Factor ETF (VFLQ), which owns stocks that trade less often. While there is “some degree of risk” in owning such stocks, Vanguard believes the approach offers capital-appreciation potential because lower-liquidity stocks can be slower to react to constructive news, says John Ameriks, who heads Vanguard’s quantitative equity group.

5. Are they better for certain strategies?

Maybe for bonds. “With rates rising in the U.S., investors who hold a passive, fixed-income ETF could be exposed to a lot of risks, including interest-rate risk,” says Patrick O’Connor, who heads ETFs globally at Franklin Templeton. The main bond benchmark, the Bloomberg Barclays Aggregate Bond Index, tilts heavily toward rate-sensitive government bonds, he notes.

“Because an active bond ETF doesn’t have to track an index, its manager isn’t forced to own risks for which investors aren’t being adequately compensated,” Mr. O’Connor adds. Franklin Templeton offers seven actively managed fixed-income ETFs, including two that invest in municipal bonds and one that holds higher-yielding floating-rate securities.

Some advisers believe an active ETF is a better way of investing in emerging-markets stocks, a survey by Brown Brothers Harriman found. Because emerging markets trade less efficiently, it is thought that an active manager can find undervalued securities more easily there than in developed markets and beat an index, says Shawn McNinch, an ETF specialist at the firm.

6. Why wouldn’t I want to buy them?

People who already own purely passive ETFs would end up paying more in management fees if they invest in active ETFs. Equity index funds from Charles Schwab and State Street charge as little as 0.03 percentage point in fees. Active ETFs likely will draw more investors away from mutual funds than from passive funds, says Brian McCormick, a senior ETF analyst at Commonwealth Financial Network.

Actively managed ETFs also aren’t for investors who hate doing research. Analyzing one thoroughly requires about the same due diligence as looking at a traditional mutual fund, says Michael Iachini, who heads manager research for Charles Schwab Investment Advisory.

It is important to delve beyond performance figures and read fund literature, such as the prospectus, to learn what an active ETF manager is trying to do and what risks that involves, Mr. Iachini adds.

7. Anything else I need to know about them?

The beauty of many actively managed ETFs is that they may give investors access to the same strategies that are used by popular mutual funds, but in a lower-cost ETF version, says Ben Johnson, director of global ETF and passive strategies research at Morningstar. He cites Davis Advisors, which recently launched several active funds. These include Davis Select Worldwide ETF (DWLD), similar to its strongly performing Davis Global mutual fund (DGFAX).

But it is important to keep in mind that in actively managed ETFs, investors are relying much more on manager skill than with older ETFs, where the strategy is embedded in the design of an index.

In some respects, investing in an actively managed ETF isn’t any different from owning a traditional mutual fund, Mr. Johnson says. “You are relying on the judgment of an individual or group of managers to find securities that they think will have greater price appreciation than others.”

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