Funds like ETFs and mutual funds can help you build a diversified mix of investments. As the ETF market has evolved, different types of ETFs have been developed. They can be passively managed or actively managed. Passively managed ETFs attempt to closely track a benchmark (such as a broad stock market index, like the S&P 500), whereas actively managed ETFs intend to outperform a benchmark.
There are 2 types of actively managed ETFs—traditional actively managed ETFs and the recently approved semi-transparent active equity ETFs. Let’s dig deeper into traditional actively managed ETFs.
Actively managed ETFs in focus
The underlying concept behind an actively managed ETF is that a portfolio manager adjusts the investments within the fund as desired while not being subject to the set rules of tracking an index—like a passively managed ETF attempts to do. The active fund manager aims to beat a benchmark using research and strategies. Traditional actively managed ETFs (as well as passively managed ETFs) report their positions daily and are priced throughout the day. This is one of the differences between an actively managed ETF and a comparable mutual fund.1
Perhaps because portfolio managers generally do not want to divulge their next portfolio move for fear of front-running (i.e., a third party identifies and makes the same trade right before the fund executes its trade), actively managed stock ETFs have not proliferated to the extent of passively managed ETFs (see Semi-transparent ETFs sidebar).
Potential advantages and disadvantages of actively managed ETFs
It's important to understand the potential advantages and disadvantages of traditional actively managed ETFs before considering one of these investment choices. Advantages relative to some other investments include:
- Potentially higher returns. Whereas a passively managed ETF attempts to track the performance of a benchmark, actively managed ETFs have the opportunity to outperform the benchmark through investment decisions by portfolio managers and research analysts. Of course, the fund might underperform the benchmark as well.
- Potentially lower cost vs. comparable funds. The structure of an actively managed ETF can enable it to have lower expenses vs. a comparable mutual fund.
- Tax efficiency. The share creation and redemption process can possibly result in ETFs being more tax-efficient than a comparable mutual fund because the process is done "in-kind," which is not a taxable event.2
- Flexibility. Like index ETFs, actively managed ETFs allow investors to trade throughout the day, including short sales and buying on margin.3 This can also enable greater liquidity for ETFs relative to funds that do not trade throughout the day.
Of course, there are disadvantages to traditional actively managed ETFs. These include:
- Daily disclosure requirement. This could be a problem for larger funds as well as funds that hold illiquid securities. Full disclosure might hinder an active manager’s ability to make adjustments and implement a strategy with internal investment research in the portfolio, for fear of front-runners and other traders in the marketplace. Note that semi-transparent ETFs do not have this requirement.
- Deviation from NAV. Traditional actively managed ETFs may develop large premiums or discounts to NAV on volatile trading days. These ETFs may develop premiums/discounts to NAV that are larger than those of passively managed ETFs.4
- Higher costs vs. certain funds. Whereas actively managed ETFs may have lower costs relative to comparable mutual funds, they may have higher expense ratios compared with index-trading ETFs.