What Are Active ETFs?

This article was written by Keonhee Kim.

Does an investment that is low cost, actively managed, and delivered triple-digit returns in 2020 sound too good to be true? That is the case for ARK Innovation ETF ARKK. Thanks in part to that fund’s success, 2020 was a record year for exchange-traded funds--and there’s some buzz around active ETFs.

What exactly are active ETFs and how are they different from passive ETFs?

Let’s first define what an ETF is. An ETF is an investment vehicle that combines the features of stocks and mutual funds. It is listed on an exchange like a stock, but invests in a collection of stocks and bonds like a mutual fund. First launched in 1993, the earliest ETFs were passive investments. They were designed to track an index (such as the S&P 500 or the Nasdaq), providing investors with exposure to hundreds of stocks in an index in a single trade. Managers weren’t actively buying or selling securities in an effort to beat an index; passive ETFs were meant to strictly mimic the performance of a particular index, minus their expenses.

However, as passive ETFs gained investors’ attention, a new type of ETF emerged: active ETFs.

First introduced by Bear Stearns in 2008, active ETFs are run by fund managers who pick stocks and/or bonds in an effort to beat the market. Like passive ETFs, active ETFs also have benchmarks. But active ETFs are trying to beat that benchmark through active security selection, sector allocation, and so on.

Active ETFs currently play a minor role in the overall ETF market. There are 500-plus actively managed ETFs in the United States and they accounted for about $193 billion in assets under management as of January 2021. While that sounds a lot, it is less than one fifth of the overall number of ETFs and just 3.5% or so of the trillions of dollars that are invested in ETFs. However, active ETFs are growing rapidly and there are many newcomers in the active ETF market: Fidelity launched active ETFs that mimic its flagship strategies, Capital Group is launching its own active ETFs, and Dimensional Fund Advisors will convert six of its mutual funds into active ETFs later this year. But among all active ETF players, Cathie Wood and her team at the ARK family of funds stand out. All five ARK active ETFs delivered gains in excess of 100% in 2020 and accounted for 40% of new active ETF money in the 12-month period ended in January.

One of the catalysts behind the recent surge in active ETFs is their ease of access. If you want to invest in an actively managed product, mutual funds and ETFs are your two primary options. While both vehicles might take similar investing approaches, their barriers to entry are vastly different. Actively managed mutual funds usually require a minimum investment and sometimes that minimum investment hurdle may be too high for an investor. Active ETFs, on the other hand, do not have investment minimums. ARK Innovation ETF trades at $130 per share at the time of writing, a much more accessible price point for investors. On top of this, many brokerages have implemented commission-free trading, making ETFs affordable and accessible options.

In addition, active ETFs often fare better than mutual funds when it comes to taxes. Mutual fund managers may have to sell shares to meet redemptions, triggering capital gains for investors who remain behind, but ETFs are structured differently. "Because ETFs can send securities out of the portfolio in kind without actually liquidating them in order to meet redemption requests, it means they've tended to be much more tax-efficient relative to mutual funds, which oftentimes have to sell down positions to give shareholders their money back," explains Ben Johnson, Morningstar's director of global ETF research. Their structure makes ETFs more tax-efficient than mutual funds.

A compelling argument in favor of mutual funds, however, is that they can close to new investors to preserve their strategies while ETFs cannot. Why does that matter? When asset managers think a particular fund or strategy has reached its capacity, it can stop or slow new money from coming in by closing the fund to all investors or to a particular group of investors. (For instance, a fund might stay open to existing customers but close itself off from newcomers.) ETF managers, in contrast, don’t have that luxury. “They would have to add that dollar to positions that may have appreciated in value and no longer look like compelling valuations,” explains Johnson. “They may have to allocate that next dollar to their next-best ideas, which could also risk diminishing the efficacy of their strategy, hurting their performance.”

Active ETFs can be great choices for investors who want to pursue active management. However, active management does necessarily mean higher returns over longer periods of time. Moreover, active ETFs generally charge higher fees than their passive counterparts. Investors have to pay more for active management regardless of the fund’s performance.