While a passive ETF has the objective of replicating the returns of the selected benchmark, an active ETF aims to differentiate itself and produce a better performance using portfolio manager’s selection skills.
How Does an Active ETF Work?
Active ETFs bring along the same advantages and interesting features of passive ETFs: for instance trading during market hours, transparency and relatively competitive pricing.
However, with regards to an active ETF the fund manager has a higher degree of freedom in terms of investment strategy, without being constrained by specific index rules (which, to some extent, might still be present and followed). This means concretely that single stock weights and sector allocations for example can be changed. The fund manager’s beliefs and ideas partially drive the investment choices. This has the goal of generating more value for the fund’s shareholders.
An active approach could result beneficial especially during market downturns. In this case more selectivity and focus on the companies’ specifics could potentially pay off.
Headwinds of an Active ETF
Since much more work and people are involved regarding the definition and implementation of specific investment views, active ETFs usually charge a higher price than passive ones. There has in fact to be a team who engages actively to implement the strategy.
Moreover, it has been the case in the past that expensive active ETFs ended up not delivering any outperformance over the reference benchmark. The popular SPIVA scorecard, developed by Morningstar, could be taken as a metric with regards to this topic. It measures in fact each year the percentage of active funds divided per region that ended up underperforming or outperforming their reference benchmark.
It is, in fact, also a matter of which broad investment philosophy do investors believe in. Some, given the levels of efficiency of financial markets, believe in the impossibility of beating reference indices while others instead do.
For Whom is an Active ETF Most Appropriate?
Investors aiming to combine the properties of an ETF with those of an active investment strategy, might want to consider an active ETF. By paying a fee surplus, they believe in the possibility of achieving higher returns than the selected benchmark, thanks to the investment choices of the fund manager. Accordingly, investors need to deeply trust the capabilities and expertise of the team.
Example: VanEck Smart Home Active UCITS ETF
This active ETF offers exposure to the fast-growing ecosystem of the smart home. Many companies are at the forefront of this sector, investing heavily in remote learning, work from home solutions, digital healthcare, delivery services and many more. Risks to bear in mind are for example the stock market risk, industry and sector risks as well as the one stemming from limited diversification.
Summary: Active vs Passive ETFs
| Feature | Passive ETFs | Active Transparent ETFs |
| Seeks Outperformance | x | |
| Tracks an Index or a Benchmark | x | |
| Trades Throughout the Day | x | x |
| Reports Holdings at the End of the Day | x | x |
| Tax Efficient Structure | x | x |
| Relative Cost | Low | Moderate |