What Are Actively Managed ETFs and Do They Work?

Actively managed ETFs are becoming the go-to choice for investors looking to harness flexibility and higher returns. But do they really work, and are they worth the hype? Let’s dive in.

What Are Actively Managed ETFs?

Actively managed exchange-traded funds (ETFs) are a dynamic breed of ETFs designed for investors who want more than just to mirror an index. Unlike passive ETFs, which track an index, actively managed ETFs have a team of portfolio managers selecting and shifting assets in real time. The active management approach aims to outperform the market by making deliberate investment decisions. Essentially, they’re the next evolution for those wanting the best of both worlds: the flexibility of ETFs combined with professional management.

Active ETFs trade like stocks, meaning you can buy or sell shares throughout the trading day. The active manager works continuously to analyze market conditions, adjust portfolios, and hunt for investment opportunities. This hands-on involvement offers investors a unique edge, especially in unpredictable market environments.

How Do Actively Managed ETFs Differ from Traditional Mutual Funds?

You might think actively managed ETFs sound a lot like mutual funds, and you’re not entirely wrong. But the devil is in the details.

• Trading Mechanism: Traditional mutual funds are bought or sold at the net asset value (NAV) at the end of the trading day, whereas actively managed ETFs can be bought or sold anytime during market hours, just like stocks.
• Tax Efficiency: Due to the “in-kind” creation and redemption process of ETFs, actively managed ETFs often have a tax advantage over traditional mutual funds. This means fewer capital gains distributions and, therefore, potential tax savings.
• Transparency: Unlike mutual funds that may report holdings monthly or quarterly, actively managed ETFs are required to disclose holdings daily. This level of transparency can be a game-changer for investors.
• Fee Structure: Actively managed ETFs usually have lower fees compared to traditional mutual funds due to fewer distribution costs.

Simply put, actively managed ETFs offer the flexibility, transparency, and cost-efficiency of ETFs combined with the tailored investment strategies of mutual funds.

Structure and Management

The structure of actively managed ETFs is similar to that of passive ETFs, but with a key difference—the role of the fund managers. The managers of actively managed ETFs make strategic investment decisions based on current market conditions.

• Portfolio Managers: Actively managed ETFs have skilled fund managers and investment teams that are constantly on the lookout for opportunities to buy undervalued securities and sell overvalued ones. The expertise of portfolio managers plays a central role in the success of these funds.
• Creation and Redemption Process: Like other ETFs, actively managed ETFs follow a unique creation and redemption process involving authorized participants. This helps maintain liquidity while also keeping fees relatively low.
• Daily Adjustments: Unlike passive ETFs, actively managed ETFs require continuous adjustments based on the active manager’s strategies, which could include investments in different asset classes such as equities, bonds, and even high-yield securities.

Investment Strategies

Actively managed ETFs employ a broad range of strategies to achieve their investment objectives. These strategies are highly adaptable and often designed to capitalize on specific market opportunities.

• Growth and Value Investing: Many actively managed ETFs follow traditional growth or value investing styles, identifying undervalued companies or those with strong growth potential.
• Income Generation: Certain actively managed ETFs focus on income by investing in high-yield bonds, dividend-paying stocks, or other income securities to generate steady returns.
• Risk Management: Some strategies prioritize risk management, focusing on reducing downside risk by adjusting allocations based on market volatility or economic conditions.
• Thematic Investing: Actively managed ETFs sometimes take a thematic approach, focusing on sectors like technology, renewable energy, or even international stocks to leverage niche opportunities.

Fees and Expenses

Fees are one of the most critical factors for any investor to consider. Actively managed ETFs usually charge higher fees than passive ETFs due to the need for active management. However, these fees are often lower than those of mutual funds because ETFs generally have fewer distribution expenses and transaction costs.

• Management Fees: These fees compensate fund managers for their expertise and time. They are expressed as a percentage of the fund’s assets under management.
• Expense Ratios: Actively managed ETFs have expense ratios that include various costs associated with managing the fund. Although they tend to be more expensive than passive ETFs, they still maintain a competitive edge compared to many actively managed mutual funds.
• Transaction Costs: While buying and selling shares of ETFs, investors must also consider trading costs such as brokerage fees. However, these are typically minimal in the grand scheme.

Key Features of Actively Managed ETFs

Liquidity

Actively managed ETFs offer high liquidity, which allows investors to trade on a daily basis at market prices. Thanks to the creation and redemption process, these funds can adjust the number of shares in response to demand, ensuring liquidity for both large institutional investors and retail investors.

• Secondary Markets: Actively managed ETFs are traded on secondary markets like the New York Stock Exchange or the London Stock Exchange Group, making them accessible to investors at different points throughout the trading day.
• Price Transparency: Since actively managed ETFs are listed, investors can see real-time market prices, which helps in making informed buying and selling decisions.

Tax Efficiency

• Capital Gains Distributions: Actively managed ETFs generate fewer taxable capital gains distributions, which ultimately reduces the tax burden on investors.
• Tax-Advantaged Structure: This structure is especially advantageous for investors looking to minimize their tax liabilities while still accessing actively managed strategies.

Transparency

Transparency is one of the hallmarks of actively managed ETFs. Unlike mutual funds that may disclose holdings quarterly, actively managed ETFs provide daily transparency regarding their assets, making it easier for investors to know where their money is invested.

• Daily Holdings: Investors have access to the exact breakdown of assets held by the fund, allowing for a better understanding of the fund’s strategy and risk exposure.
• Enhanced Trust: This level of transparency builds trust among investors, allowing them to align their portfolio more accurately with their investment goals.

Performance Trends of Actively Managed ETFs

Historical Performance Analysis

Historical performance is a mixed bag when it comes to actively managed ETFs. Some have outperformed benchmarks, while others have struggled to keep up. The success of an actively managed ETF often depends on the skill of the portfolio managers and the market conditions.

• Market Conditions: In volatile or bearish market conditions, actively managed ETFs can provide better returns than their passive counterparts by adjusting holdings to navigate market risks.
• Examples of Strong Performers: Certain actively managed ETFs, such as those managed by Capital Group or BlackRock, have demonstrated strong returns due to efficient market timing and sound asset allocation decisions.

Comparison to Passive ETFs

• Flexibility: Passive ETFs are locked into following an index, whereas actively managed ETFs can quickly adjust to take advantage of market inefficiencies or emerging opportunities.
• Cost Considerations: Actively managed ETFs usually come with a higher expense ratio than passive ETFs. However, investors seeking potential outperformance might find the additional cost justifiable.

Benefits of Investing in Actively Managed ETFs

Dynamic Investment Approach

The dynamic approach of actively managed ETFs makes them highly adaptable to changing market conditions. Unlike passive funds that mimic an index, active ETFs have the flexibility to adjust their portfolio according to shifts in the economy or specific sectors. This adaptability can be crucial for investors seeking to manage market volatility.

Potential for Higher Returns

Actively managed ETFs provide the potential to outperform traditional passive funds. Skilled active managers employ different strategies to identify the best opportunities, which can lead to excess return. These funds are ideal for investors aiming to beat the market benchmarks, though it’s important to remember that higher returns also come with greater risks.

Flexibility in Market Conditions

In uncertain market environments, the ability to quickly adapt can make a big difference. Actively managed ETFs provide that edge by allowing investment managers to adjust holdings and asset classes depending on prevailing market trends.

• Proactive Adjustments: Fund managers can change holdings during difficult credit markets or economic downturns to better position the ETF for stability or growth.
• Strategic Allocation: By focusing on a broad range of asset classes, from high-yield bonds to equity exposure, actively managed ETFs can weather different market conditions effectively.

Risks Associated with Actively Managed ETFs

Manager Risk

The performance of an actively managed ETF is highly reliant on the expertise of its fund managers. If the active manager makes poor investment decisions, the ETF could significantly underperform.

• Pressure on Fund Managers: Fund managers face constant pressure to outperform benchmarks, which can lead to risky or poorly-timed investments.
• Subjectivity: Unlike passive funds that follow a set index, actively managed ETFs rely on the judgment and skill of their managers, making them subject to human error.

Market Risk

As with any investment, actively managed ETFs are exposed to market risk. Economic conditions, market volatility, and unforeseen financial events can all have a negative impact on an actively managed ETF’s performance.

• Global Factors: Changes in international stocks, economic policies, or currency exchange rates can influence the value of actively managed ETFs.
• Sector-Specific Risks: Since some actively managed ETFs invest in specific sectors like technology or renewable energy, they are subject to sector-specific risks and fluctuations.

Tracking Error

Actively managed ETFs may deviate from their intended investment objective due to tracking error. This occurs when the fund’s portfolio doesn’t perfectly align with its benchmarks, leading to performance discrepancies.

• Active Strategies: Unlike passive investments that aim to match a benchmark, actively managed ETFs may deviate from standard performance metrics as a result of taking on specific active strategies.

Do Actively Managed ETFs Beat Market Benchmarks?

Studies and Research Findings

Several studies have attempted to answer the question of whether actively managed ETFs outperform the market. The results have been mixed, often depending on the time frame analyzed and the market conditions during that time.

• Morningstar Direct Findings: Research by Morningstar Direct suggests that actively managed ETFs can outperform benchmarks during periods of high market volatility. However, during bull markets, passive strategies often win out.
• Fund Metrics: Performance depends heavily on the individual metrics of each fund. While some actively managed ETFs outperform their benchmarks, others lag significantly due to poor asset allocation decisions or management risk.

Factors Affecting Performance

• Market Timing: Active ETFs that excel in market timing tend to outperform. This is particularly true in markets where inefficiencies exist and can be exploited.
• Manager Skill: A talented fund manager who can effectively read market conditions is key to an actively managed ETF’s success.
• Sector and Thematic Focus: ETFs focusing on niche sectors, like technology or international stocks, can provide substantial returns if those sectors perform well.

Popular Actively Managed ETFs to Consider for 2024

Top Funds by Performance

• ARK Innovation ETF (ARKK): Managed by Cathie Wood, this ETF focuses on disruptive technologies and has shown significant returns, albeit with high volatility.
• JP Morgan Equity Premium Income ETF (JEPI): This ETF focuses on generating attractive income while maintaining equity exposure. It’s an ideal choice for investors looking for income ETFs.
• Capital Group Dividend Value ETF (CGDV): This ETF focuses on dividend-paying stocks, combining value investing with a focus on income securities.

Emerging Trends in Actively Managed ETFs

• Thematic and Sector Focus: Expect to see a continued rise in thematic actively managed ETFs, focusing on specific sectors like clean energy, technology, and international investing.
• Semi-Transparent ETFs: These funds allow fund managers to maintain proprietary investment strategies without full daily disclosure of holdings, making them an interesting twist in the ETF world.
• Active Bond ETFs: In the bond market, actively managed bond ETFs are gaining popularity, particularly those focusing on high-yield bonds or short-duration bonds to navigate interest rate risk.

Conclusion

Actively managed ETFs have carved out a niche by offering a hands-on approach that caters to dynamic market environments. They provide the opportunity for higher returns, tax advantages, and flexibility that traditional mutual funds or passive ETFs might lack. However, they are not without risks. Whether actively managed ETFs are right for you depends on your risk tolerance, investment goals, and how much faith you put in active management over passive strategies.

If you are ready to explore the world of actively managed ETFs, it’s worth consulting with a financial professional to determine which funds align best with your objectives and risk profile.

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