Are active ETFs right for you?

A rule change has led to more active ETF choices for investors. See why.

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Key takeaways

  • A regulatory shift in recent years means that some ETFs no longer have to disclose holdings daily.
  • This has led to an increase in the availability of actively managed ETFs.
  • Actively managed stock ETFs had not previously been offered widely, due to the potential opportunity costs associated with daily holdings disclosure.

The growth in exchange-traded funds (ETFs) has been astronomical since the first ETF launched in 1993. The ETF universe exceeds $6 trillion in assets under management.

Many investors and financial advisors like ETFs because they can offer tax advantages compared to some other alternatives, can be traded intraday, and offer transparency into underlying holdings, among other potential benefits. The degree of transparency is the differentiator between the new active stock ETFs and the vast majority of ETFs in the market today. And there are now more active ETFs than ever before.

A game changer for actively managed ETFs?

Many investors seek actively managed investments (like many mutual funds and ETFs) based on the belief that rigorous research, sophisticated portfolio construction, and expert trading may add value for shareholders. Actively managed ETFs are a portfolio of subjectively chosen investments by a fund manager, rather than those chosen via a rules-based index that defines a passively managed ETF. Essentially, active ETFs combine the potential benefits of an ETF structure with those of active management. The idea is to perform better than a benchmark index through flexible active management.

However, investments that combine the benefits of active stock picking and an ETF structure have not meaningfully taken off up to this point. Most fund managers have not broadly offered active ETFs because there are potential costs associated with full transparency in the form of daily holdings disclosure (which had historically been required of ETFs).

In recent years, the Securities and Exchange Commission (SEC) has granted an exemption to a handful of firms, allowing them to offer actively managed ETFs that are not required to disclose daily holdings. You may see these funds referred to as semi-transparent ETFs elsewhere. Investors can maintain transparency with access to most recent public holdings and, in some cases, into the fund’s current exposures and drivers of risk and return through daily proxy portfolios.1

The rule change has steadily made actively managed equity ETFs more widely available in the marketplace. Of course most, if not all, of the existing risks associated with ETFs also exist for actively managed ETFs (see disclosures for important information on additional risks associated with active ETFs). However, this innovative ETF structure has the potential to allow investors to capture more of the outperformance that active managers seek to provide by mitigating some front-running and trading risks.

The risk of front-running

How might actively managed ETF investors benefit from this rule change? By revealing holdings too often, active managers risk signaling their investment intent to the market. This information could lead other market participants to "front-run" trading decisions—an act that can threaten the returns of both actively and passively managed strategies. When other market participants can detect a fund's upcoming purchase, as an example, they can get ahead of that trade and thus bid up the security's price, resulting in a potential reduction of the strategy’s returns.

With non-transparent ETFs, the relaxed holdings disclosure for active ETFs may allow fund managers to preserve more of the potential shareholder value associated with active management.

Academic research has demonstrated that the front-running of active investment strategies has had an impact on fund performance. Market participants have been able to exploit front-running opportunities using previously disclosed holdings.

Further, following a 2004 SEC policy change that required mutual funds to increase the frequency of holdings disclosure from semi-annually to at least quarterly, a 2015 study examined the impact of the shift on fund shareholders. The research showed that as fund managers revealed their trading activity to the market more frequently, some ability to deliver excess returns was lost—largely as a result of front-running.2 Consequently, front-running could be even more costly to active ETFs, which have historically disclosed their holdings more frequently (i.e., daily) than traditional mutual funds.

The value of research

As part of a fund's management fee, investors pay active managers to conduct company research to identify stocks that might outperform and those that might underperform. Such research decisions have the power to add to shareholder returns.

However, those returns may take time to materialize in trading activity across a suite of funds, as individual managers make investment decisions based on their specific portfolio construction and risk mandates. If these research insights are revealed to the market before the desired investment position can be established, that can erode the potential value.

Flexibility to trade over time may enhance performance

To determine how quickly to build or reduce a position, traders use their expertise to balance the cost of liquidity with the risk of not executing a trade all at once (should market volatility lead to significant price changes). Because mutual funds and ETFs often trade in large volumes, asset managers frequently spread trades out over multiple days to reduce costs.

Disclosing trading activity to the market while positions are still being built or reduced could allow for increased front-running and preclude cost-saving trading strategies, thus leading to lower net performance. Opportunistic or algorithmic trading strategies could reduce trading costs even further for actively managed ETFs that are not required to disclose holdings daily. ETFs that do not need to disclose holdings daily may benefit from the ability to implement trading strategies that preserve more of the potential active management value for shareholders.

Investment implications

The shift to enable some firms to offer ETFs without the requirement to disclose holdings daily may help reduce the potential costs to shareholders associated with full transparency. At the same time, these new ETF structures are designed to provide transparency into the funds’ holdings and drivers of performance.

This change has led to greater access for investors who are seeking the benefits of ETFs and who believe in the potential of active management.

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