What Investors Should Know About Active ETFs

 Debbie Carlson
  29th-Dec-2017

When investors think of exchange-traded funds, they think of passive, index-following securities.

However, active ETFs are a small but growing part of the industry. Rather than try to match a benchmark, these ETFs try to exceed it, not unlike actively managed mutual funds. There are about 200 active ETFs, with roughly 50 of them launched this year. These funds make up only a fraction of the nearly $4 trillion ETF universe, but their numbers are growing quickly.

ETFGI, a London-based independent research and consultancy firm, says active ETFs and exchange-traded products gathered a record $24 billion in net new assets in the first 11 months of 2017, up 53.4 percent from the previous year and the greatest annual increase since 2009.

That sort of growth has some ETF issuers using the word "active" when naming or describing their products, but those securities are really still passive ETFs in active clothing, ETF industry watchers say. For investors interested in active ETFs, it takes looking a little deeper to understand how the fund is constructed to see if it is truly active – and whether they want these types of funds in their portfolio anyway.

Three ETF categories. Sean O'Hara, president of Pacer ETFs in Paoli, Pennsylvania, says there are three ETF categories. The first are the original ETFs, which he calls the "truly passive." These ETFs simply track an index, such as the SPDR S&P 500 ETF Trust (ticker: SPY), the world's biggest ETF, which tracks the Standard & Poor's 500 index. The next category is fundamental ETFs, sometimes called factor or smart-beta ETFs. These also track an index, but use a rule to change holdings, such as if the S&P 500 falls under the 200-day moving average.

"They're still considered technically a passive strategy, even though the holdings can change," O'Hara says. "They're still passive, but they're not static."

Active ETFs fall into a third category, where a portfolio manager makes decisions about what security the fund should or shouldn't own, he says.

The active ETF growth comes as the industry is maturing, says Christian Magoon, chief executive officer of Amplify ETFs in suburban Chicago, an industry veteran who has created and launched many ETFs.

"There are a variety of investment strategies that don't fit neatly into the predetermined rules-based investment approach of indexing," he says, such as fixed-income ETFs.

The fixed-income market segment is quite a bit younger than equity ETFs, and that sector is also viewed as a more complex market segment due to interest rate, credit and liquidity risks, which make them good candidates for active ETFs, Magoon says.

Look under the hood. Because of the rising interest in active ETFs, some ETF issuers may call their strategy active when it really follows a fundamental or smart-beta strategy, which is still passive, says Matt Schreiber, president and chief investment strategist at WBI Investments in Red Bank, New Jersey.

"A true active ETF is not constrained to a benchmark," he says.

Magoon says to ensure the active ETF you're considering is really active, check the investment objective section of the ETF's prospectus, which should explain if the approach is active or if the ETF is tracking an index.

"Language in the investment objective section of the ETF's prospectus about outperforming an index or market segment is an easy way to know the ETF is active," he says. "Comparing the ETF's underlying holdings – amount of holdings, weight of holdings in terms of market cap, sector and perhaps country exposure, frequency of portfolio turnover – to the benchmark being targeted is a an easy way to see if the active approach is truly being implemented by the ETF."

There are a few key differences between active and passive ETFs in terms of fees and potential tax implications. Magoon and O'Hara say active ETFs are usually more expensive than passive ETFs and have higher portfolio turnover. ETFs are known for being more tax-efficient than mutual funds, but O'Hara says truly active ETFs may have higher taxes. "If you're a manager who has had some capital gains that you can't offset with losses, you need to pass those on," he says.

Active ETFs act similar to mutual funds, which are also actively managed. So why might investors choose one over the other? O'Hara says there are two main benefits: timing and fees.

ETFs trade throughout the day, so when investors buy or sell, they usually get the price the ETF was trading at during the order execution. With mutual funds, the investor won't know the price until the end of the day. Additionally, mutual funds can have extra or higher fees than ETFs, which eat into performance, O'Hara says. His company does not operate any active ETFs.

Kip Meadows, chief executive officer at Nottingham, outside of Raleigh, North Carolina, owns the Fieldstone Merlin Dynamic Large Cap Growth (FMDG), an active ETF. The lower fees versus a mutual fund is one reason why he holds the fund, he says. He also likes the active ETF over passive ETFs because in many indexes, holdings may be equally weighted, even though the health of the companies is different.

"The problem I have with index investing is, say you have an index and has three oil stocks in it – BP (BP) Exxon (XOM) and Shell (RDS.A)," he says. "If you buy an index, you buy all three of them in whatever proportion to the index."

With an active ETF, the fund may still hold those companies but at different weightings, and the individual names can be bought and sold at different times, rather than as a group, which would happen with an indexed ETF.

"If you're making some choices using data, knowledge, experience or whatever that goes into making an investment decision, you have an opportunity do better than the blind index," Meadows says.

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