An actively managed ETF is a type of exchange-traded fund in which the underlying portfolio allocation is decided by a manager or team, rather than following a passive investment strategy.
Although an actively managed ETF will have a benchmark index, managers can adjust sector allocations, make market-time trades, and diverge from the index as they see suitable. This results in investment returns that aren’t exactly the same as the underlying index.
How are Active ETFs profitable?
Because actively managed ETFs are more difficult to create, they are not as commonly available. All of the primary challenges that money managers face are related to a trading complexity, notably a complication in the role of arbitrage for ETFs. Because ETFs are traded on a stock market, price differences between the trading price of the ETF shares and the trading price of the underlying assets are possible. Arbitrage becomes possible as a result of this.
If the price of an ETF is lower than the price of the underlying stock, investors can profit from the difference by purchasing ETF shares and then exchanging them for in-kind distributions of the underlying company. Investors can short the ETF and cover the position by purchasing shares of stock on the open market if the ETF is trading at a premium to the value of the underlying shares.
Arbitrage keeps the price of index ETFs near to the value of the underlying shares with index ETFs. This works because everyone is aware of the index’s holdings. By declaring their holdings, the index ETF has nothing to fear, and price parity is in everyone’s best interests.
An actively managed ETF, whose money manager is compensated for stock selection, would be in a different scenario. Those choices should, in theory, help investors exceed their ETF benchmark index.
There would be no motivation to buy the ETF if it published its holdings frequently enough for arbitrage to occur; clever investors would just let the fund management conduct all of the research and then wait for the revelation of their best ideas. The investors would then purchase the underlying securities, so avoiding the fund’s management costs. As a result, money managers have little motivation to establish actively managed ETFs in such a circumstance.
However, in Germany, Deutsche Bank’s DWS Investments business produced actively managed ETFs that reveal their holdings to institutional investors on a daily basis with a two-day delay. However, the information is not released to the broader public until it has been one month. This setup allows institutional traders to arbitrage the fund, but also feeds the general public outdated information.
Active ETFs have been permitted in the United States, but they must be transparent about their daily holdings. In 2015, the Securities and Exchange Commission (SEC) disallowed non-transparent active ETFs, but it is now considering several models of regularly reported active ETFs. On volatile days involving ETFs, the SEC has also permitted opening stock trading without price disclosures to avoid the record intraday drop that occurred in August 2015, when ETF prices fell as securities trading paused while ETF trading continued.
Potentially for higher returns
One advantage of an actively managed ETF is the possibility of outperforming the market. While only a small percentage of investment management teams outperform the market, those that do tend to earn large gains over a short period of time.
Greater flexibility and liquidity
Active ETFs may also offer more flexibility in times of market volatility. Passive investors have little choice but to ride along with global events that shock financial markets.
Actively managed funds, on the other hand, may be able to respond to changing market conditions. Portfolio managers may be able to rebalance investments based on current trends, so limiting losses or even benefitting from panics and selloffs.
Active funds, like passive ETFs, trade throughout the day (as opposed to some mutual funds, which only modify their price once a day), allowing investors to do things like short shares or buy them on margin.
Higher expense ratios
The possibility of a higher expense ratio while investing in an actively managed ETF is one downside. Expense ratios for active funds, whether ETFs or mutual funds, are often higher. The price of hiring a professional or a team of specialists, as well as the fees connected with further purchasing and selling of investments, usually add up to higher expenditures over time.
A brokerage fee may be charged for each purchase or sell, especially if the securities are foreign-based. Because these costs are larger than those of passive funds, the expense ratios are higher.
Performance factors
The majority of active ETFs do not strive to offer higher returns. The fact that the majority of actively managed funds (as well as most individual investors) do not outperform the market over time is a well-known truth in the financial world.
While an active ETF may have the potential for higher gains, it also has a higher risk of lower returns or even losses. Choosing an active fund that fails to outperform its benchmark has a higher likelihood of failing than choosing one that succeeds.
Bid-ask spread
The bid-ask spread of ETFs varies, and while it’s generally better to invest in an ETF with a narrower bid-ask gap, this is dependent on market conditions as well as the fund’s liquidity and trading volume. Investors should be aware of the bid-ask spread in order to cut costs.
Index ETFs Are Passive Investing Vehicles
Index ETFs are designed to track the performance of a specific index. In general, active ETFs attempt to outperform a benchmark index.
Index ETFs are passive investment instruments that rely nearly exclusively on the performance of an underlying market index. To track the index and replicate its performance, fund managers buy and sell assets.
Market indexes are used as benchmarks in active ETFs. Rather than trying to replicate or follow the performance of a specific index, they endeavor to outperform it. Although outperforming an index over the long term is difficult, if an active ETF’s fund manager plays their cards well, investors may see higher returns.
Index ETFs Have Lower Costs
The lower expense ratios of index ETFs are a significant benefit. While paying a higher expense ratio may make sense if you’re looking for a fund with a specific strategy, index funds tend to provide higher average returns with lower average costs over time.
While a 0.50 percent difference may appear insignificant, it can add up to tens of thousands of dollars over the years. For example, if you invested $6,000 per year for 30 years and had 6% average annual returns, an active ETF charging the average fee would cost you $44,000 more than an equity index ETF.
Active ETFs Respond to Current Events
The capacity of actively managed ETFs to adjust to quickly shifting markets is a significant benefit.
“Index funds are built on the status quo at a time when the economy and the way we operate are fast changing,” Meadows explains. “Some companies could be deleted from an index for a year or more before the changes are reflected in an index ETF.”
Active portfolio managers alter their holdings as often as necessary, allowing them to quickly replace companies whose stock prices have been slashed by recent events. Some investors may find this type of responsiveness appealing.
Index Funds Offer Stable Long-Term Returns
According to S&P Global, more than 87 percent of actively managed funds have underperformed their benchmarks over the last 15 years. The S&P 500 had an average yearly return of 8.9% with dividends reinvested throughout the same time period, which includes the Great Recession.
According to Berlinda Liu, head of Global Research & Design at S&P Dow Jones Indices, actively managed funds have underperformed benchmark performance even in 2020, a year characterised by volatility and economic instability.
However, not all actively managed ETFs strive to exceed benchmarks; some just seek to provide good returns of some kind, regardless of market conditions.
Are ETFs capable of making you wealthy?
Even if you earn an average salary, this diligent technique can turn you into a billionaire. With a single purchase, you can become an investor in hundreds of firms through an exchange-traded fund (ETF). If you want to retire a millionaire, the Vanguard S&P 500 ETF (NYSEMKT: VOO) might be the best option.
What are the advantages of actively managed ETFs?
- An investment manager or team is in charge of researching and making choices on the ETF’s portfolio allocation in an actively managed exchange-traded fund (ETF).
- While passively managed ETFs outweigh actively managed ETFs by a large margin, active ETFs have seen significant growth due to client demand.
- Active ETFs provide lower fee ratios than mutual fund alternatives, as well as the opportunity to trade intraday and the potential for bigger returns.
- Passively managed ETFs tend to beat actively managed ETFs over time.
Is it possible to actively manage an ETF?
ETFs and mutual funds can help you establish a diverse investing portfolio. Different types of ETFs have emerged as the ETF market has matured. They can be managed in two ways: passively or actively. Actively managed ETFs aim to outperform a benchmark (such as the S&P 500). Passively managed ETFs strive to closely match a benchmark (such as a broad stock market index).
Traditional actively managed ETFs and the newly allowed semi-transparent active equities ETFs are the two types of actively managed ETFs. Let’s take a closer look at classic actively managed exchange-traded funds (ETFs).
What distinguishes an active ETF from a mutual fund?
- With different share classes and expenses, mutual funds have a more complex structure than ETFs.
- ETFs appeal to investors because they track market indexes, whereas mutual funds appeal to investors because they offer a diverse range of actively managed funds.
- ETFs trade continuously throughout the day, whereas mutual fund trades close at the end of the day.
- ETFs are passively managed investment choices, while mutual funds are actively managed.
Are there any actively managed ETFs at Vanguard?
Vanguard launched a collection of six actively managed ETFs aimed at factor strategies more than two years ago. The move was nearly surprising, given that the company’s founder was a pioneer in the field of passive investing.
Despite the fact that John Bogle has advocated for cap-weighted indexing as a strategy for more than 40 years, Vanguard is a strong player in the active management area, with active techniques used in 70 of its 132 mutual funds.
Despite the fact that Vanguard is a big player in the active mutual fund industry, its active ETFs have lagged behind the rest of the company in terms of assets and performance. In terms of assets under management, they remain the lowest of the company’s 80 ETFs (AUM).
Seventeen of Vanguard’s ETFs have less than $1 billion in assets under management. The six factor funds have a total size of $37 million to $134 million, which is tiny change for a company like Vanguard.
Over a two-year period, we compared the performance of these six active ETFs to the dominant passive ETF in each category. The Vanguard funds trailed in each case, according to our findings.
Because those were the largest funds in their respective categories, we utilized the iShares single-factor ETFs and Goldman Sachs’ multifactor ETF.
The Vanguard U.S. Multifactor ETF (VFMF) appears to be the most equivalent to Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), the largest multifactor ETF, with a market capitalization of approximately $10 billion. Both funds are focused on the factors of value, momentum, quality, and low volatility.
VFMF has a 0.19 percent expenditure ratio, whereas GSLC has a 0.09 percent expense ratio. VFMF has 572 holdings compared to 435 for GSLC, and they share three of the top ten components. Technology is the most heavily weighted sector in both funds, accounting for 23.73 percent in VFMF and 33.34 percent in GSLC.
VFMF has strong overexposure to the low size factor of 1.17 and the value component of 0.45, according to MSCI data. Momentum has a factor loading of 0.27, and quality has a factor loading of 0.19.
That technological weighting may be the primary point of differentiation, as the performance of the two funds diverges by about 30 percentage points in favor of GSLC over the two years ending Sept. 23. The sector has outperformed the S&P 500’s other sectors.
The $47 million Vanguard U.S. Quality Factor ETF (VFQY) seeks to replicate the performance of the quality factor by investing in stocks with good fundamentals. The $19 billion iShares MSCI USA Quality Factor ETF is the largest passively managed quality-focused ETF (QUAL). Despite being an index fund, QUAL is the more expensive of the two, charging 0.15 percent versus 0.13 percent for VFQY.
In their top ten holdings, the two funds only have one stock in common: Apple. Again, technology is the greatest holding for both, but while it accounts for a quarter of VFQY’s total weight, it accounts for more than 36% of QUAL’s.
According to MSCI data, the iShares ETF has considerably more exposure to the quality element, with a quality score of 0.46 vs 0.27 for VFQY. Surprisingly, the low size factor, at 1.23, is VFQY’s largest factor exposure.
The performance gap, which is roughly 18 percentage points in favor of QUAL, appears to be driven once again by sector disparity.
The Vanguard U.S. Value Factor ETF (VFVA) is the largest in the Vanguard factor ETF family, with $118 million in assets. It has a counterpart in the $6.7 billion iShares MSCI USA Value Factor ETF (VLUE). VFVA is less expensive than index-based VLUE, with a 0.14 percent fee compared to 0.15 percent for VLUE.
With 151 holdings, VLUE is a considerably more concentrated portfolio than VFVA, which has 756 components. In their top ten holdings, the funds have five of the same companies. With a weighting of 28.24 percent, financials is VFVA’s largest sector, while technology, which isn’t even in VFVA’s top three, is VLUE’s largest sector, accounting for 25 percent of the portfolio.
VFVA has a larger exposure to the value factor (0.98 vs. 0.84) than VLUE. Low size, on the other hand, is VFVA’s greatest factor loading, at 1.43.
At the end of the two-year period, VFVA was more than 8 percentage points behind VLUE.
The Vanguard U.S. Momentum Factor ETF (VFMO), which has a market capitalization of $60 million, has a counterpart in the iShares MSCI USA Momentum Factor ETF, which has a market capitalization of over $12 billion (MTUM). Again, the iShares fund is more expensive, at 0.15 percent, it costs 2 basis points more than the Vanguard fund.
VFMO has a larger portfolio than MTUM, with 661 holdings to 127. Despite the fact that Tesla is the largest investment in both funds, VFMO weights it at 1.88 percent, while MTUM weights it at 6.53 percent, a substantial discrepancy. In total, the funds have four securities in common among their top ten holdings.
Technology is once again the most important sector for both, but the disparity in weighting is less pronounced. Nearly 32% of VFMO’s portfolio is made up of technology equities, while nearly 41% of MTUM’s is made up of them. Momentum is the largest factor exposure for MTUM, at 0.85, while it is 0.71 for VFMO, with a loading of 1.02 for the Vanguard fund.
At the end of the two-year period, the performance gap between the two was over 15 percentage points, with VFMO lagging MTUM.
The Vanguard U.S. Minimum Volatility ETF (VFMV), which has a market capitalization of $73 million, uses a proprietary model that evaluates multiple categories of risk rather than just looking for low volatility. The $34 billion iShares MSCI USA Min Vol Factor ETF is its index-based equivalent (USMV). The Vanguard fund has a 0.13 percent fee ratio, whereas the iShares fund has a 0.15 percent expense ratio.
With only 127 stocks, VFMV has the least number of holdings among the Vanguard factor ETFs, whereas USMV has 196. Only two of their top ten holdings, Verizon Communications and Merck, are the same. Technology is the top sector for both funds, although the Vanguard ETF has a bigger weighting for the sector than the iShares ETF, at nearly 29 percent vs 18 percent.
In terms of factor exposures, neither fund’s strongest factor exposure is low volatility. With a size exposure of 1.07 and a volatility exposure of 0.39, VFMV is a low-risk investment. Meanwhile, yield, at 0.26, and low volatility, at 0.11, are the two most important factors for USMV.
Nearly 15 percentage points separated the funds’ performance results at the end of the two-year period.
Vanguard has dismissed the concept that size is an issue, claiming that illiquidity, not small size, is the cause of outperformance. We compare the $36 million Vanguard U.S. Liquidity Factor ETF (VFLQ) to the $696 million iShares MSCI USA Size Factor ETF (SIZE). The expense ratio of the iShares fund is 1 basis point more than that of the actively managed Vanguard fund, which is 0.14 percent.
With these two funds, portfolio size is less of a problem. SIZE has 620 holdings compared to 779 for VFLQ. They don’t share any of their top ten holdings, and technology isn’t their major industry.
Instead, financials is the largest sector for both VFLQ and SIZE, with 32.8 percent for VFLQ and 21 percent for SIZE. However, technology is the second-largest sector in SIZE, while it is the fourth-largest in VFLQ.
Despite its concentration on the liquidity factor, VFLQ has the higher factor exposure to low size, with an exposure of 1.66, whilst SIZE has an exposure of 0.61 to the same factor.
The funds’ performance differential at the end of the two-year period appears to be driven by technology exposure and small-size exposure, with VFLQ behind SIZE by 15 percentage points.
Vanguard is recognized for its passive investing, but it doesn’t skimp on active management, offering a wide range of actively managed mutual funds. It’s remarkable that its actively managed ETFs underperform similarly managed passive products by such a large margin.
The Vanguard ETFs, on the other hand, are often underweight in the technology sector, which has outperformed in recent years. Similarly, many Vanguard funds have significant low-size factor exposure, and small caps have recently underperformed.
What determines whether an ETF is active or passive?
An index fund or an ETF are both examples of passively managed funds. In addition, the summary overview of a fund will state whether it is an index fund or an exchange-traded fund (ETF). If it doesn’t, it’s safe to think it’s being actively managed. For example, Vanguard’s REIT ETF (VNQ) declares that it is an ETF and that it invests in REITs.
The goal is to closely replicate the MSCI US Investable Market Real Estate 25/50 Index’s performance.
There are some slight variations between ETFs and index funds when it comes to investing. The most significant difference is that ETFs trade on the stock exchange throughout the trading day, whereas index fund transactions, like other mutual funds, take place at the conclusion of the trading day. Many online brokers offer commission-free ETF trading for a variety of ETFs, and the expense ratios of index funds and ETFs offered by the same provider are quite comparable, if not identical. Some index funds have high minimum opening deposits, making their ETF equivalents more accessible.
Simply look through the company’s list of ETFs or index funds to see which are on the list to discover if your funds are actively or passively managed. Vanguard has the lowest management expense ratios (and why not go with the cheapest if you’re going with a passively managed fund that tracks an index?). Here are a couple of places to begin:
Unfortunately, actively managed funds still account for a big portion of invested assets (at the price of investor performance), but you now have the knowledge to help alter that!
