How Do Active ETFs Work?

In a fast-paced world where share prices are actively rising and falling, investors are often drawn to the tried-and-true method of passive investing options like ETFs. Exchange-traded funds have been at the forefront of indexed strategies and have taken in hundreds of billions of investing dollars this year alone. But, what if an investor is looking for something that’s a little more, dare we say, active.

Through June of this year, active ETFs accounted for 70% of all ETFs launched in the US this year. Portfolio managers are pumping billions of dollars into the active ETF sector every month. So, they’re kind of a big deal. Active ETFs are meant to not just mirror the markets but outperform them.

How are wealth managers taking the traditionally set-it-and-forget-it nature of ETFs and flipping it on its head?

Before Active ETFs

ETFs are key vehicles to passive investment, and by the end of last year, the global ETF market contained almost $11.5 trillion in assets under management. Here’s a quick recap on how they work:

• Instead of buying individual stocks, bonds, currencies, or other assets, ETFs allow stakeholders to invest in bundles that contain small pieces of securities. 
• Some of the most popular ETFs are ones that follow major indexes like the S&P 500 and the Nasdaq, but investors can also buy shares in specific industries. For example, the Alerian MLP ETF tracks energy stocks.

Buffer ETFs follow the same basic structure, but include a series of call and put options to protect investors from losses; some even offer 100% downside protection.

Why do Investors Like ETFs and Active ETFs?

EFTs are attractive because they can be traded multiple times a day (just like stocks), are highly liquid, have predictable returns, and investors don’t incur capital gains taxes until they sell their shares. 

ETFs, which are passively managed, are generally cheaper investment vehicles. Some have very low expense ratios, like the SPDR Portfolio S&P 500 ETF, which is at 0.02%. ETFs resonate with people looking for an affordable and predictable investment vehicle. So let’s see what happens when that vehicle shifts into a higher gear.

What makes an ETF Active?

Active ETFs have a manager or team of advisors overseeing the fund’s holdings, and they’re not necessarily bound to the rules of any specific index or methodology. Passive ETFs tend to rebalance just a few times a year, every quarter or every half; active ETFs can be rebalanced daily depending on the manager’s strategy. 

“An active manager is constantly reviewing their portfolio, digesting research and information on a daily basis to give themselves an edge and hopefully make the right decision when it comes to the securities they’re buying and selling,” Chris Murphy, a senior ETF specialist at asset manager T. Rowe Price, told The Daily Upside.

Why are Active ETFs Getting So Popular?

In the US, launches of new active funds have outpaced their passive forerunners every year since 2020, according to Bloomberg data. A lot of that is thanks to a Securities and Exchange Commission rule change in 2019 that helped expedite the process of launching new ETFS:

• Right now, Dimensional Fund Advisors and JPMorgan Asset Management are the two largest issuers with a combined $228 billion in AUM, accounting for about 36% of total active ETF assets alone, Bloomberg reported.
• BlackRock recently launched five active ETFs in European markets, and Nouriel “Dr. Doom” Roubini — an economist who warned of the 2008 financial crisis — submitted SEC filings to launch his own, the Atlas America Fund.

The Active ETF Playbook

Active management has always been part of the investor’s playbook, but now there are more ways of accessing those strategies through the ETF model, Murphy said. 

“The ETF industry has grown significantly while the mutual fund industry has started to decline in terms of their AUM, so there’s been a clear preference toward the ETF vehicle,” he said. “Secondly, the market over the last several years has been pretty volatile. We’ve seen significant concentration in some of the indices. We’ve seen interest rates go from zero to 5% on the short end. So this has been a really good environment for active management.”

Investors enjoy active ETFs because they’re not too different from standard ETFs.

“You’re getting all the benefits of the ETF vehicle: tax efficiency, liquidity, transparency, scale,” Murphy said. “So it’s what you know and love about an ETF but with professional management.” 

What’s the Downside to Active ETFs?

Active ETFs are the cool new kid on the block, which can deter some investors. The first ETF launched in the 1990s, and the first active ETF premiered in 2008. Only in the last few years have advisory firms really begun bolstering their active ETF offerings.

“The majority of active ETFs have gone on the market in the last three years, and so investors don’t have the standard five- or 10-year track record to look at,” Murphy said. “A lot of strategies in the market are brand new. If there is only a two- or three-year track record, sometimes that’s not suitable for investors.”

What’s the Future of Active ETFs?

When active ETFs first launched, there weren’t many to choose from, and they mostly concentrated on fixed-income strategies, Murphy said. That’s changed quite a bit.

“Now, it’s pretty well-diversified — large cap equity, ultra-short fixed income, we’ve gotten a lot of interest in derivative income, options-based income, and buffer strategies,” he said. “It’s really broadening out, which in our view, is really helping.”

Currently, active ETFs represent about $900 billion in AUM, less than 10% of the ETF market. That’s not a lot (relatively speaking, obviously), but active ETFs fervor is growing fast.

In 2021, about a quarter of global ETF launches were active, and through the first half of 2024, that figure jumped to 41%, according to BlackRock. The world’s largest asset manager forecasts that active ETFs AUM will quadruple to $4 trillion, or 16% of the ETF market, by 2030. That is a lot (and not just relatively speaking).