Active ETFs – what are they and why are they becoming more popular?

Investors might be familiar with managers using mutual funds for active or passive fund management, like many of the funds on our Wealth Shortlist. However, in recent years, the ETF wrapper is being picked up by active managers, predominantly in the United States, with the aim to outperform a certain benchmark. This type of investment has become known as an active ETF.

Why are active ETFs becoming more popular?

Transparency

Active ETFs have always been possible, but they previously required managers to publish the full fund breakdown every day. For lots of active managers, this transparency is off-putting because others could replicate their process, and their ‘secret sauce’ would be lost.

Mutual funds only require managers to post the top ten holdings, meaning the rest of the fund can remain a secret to the public, which is one of the reasons why they’re popular.

When a full fund breakdown is available, there’s also the issue of front running. This is where market participants can detect a fund’s upcoming purchase and try to get ahead of that trade. This increases the share price, impacting the fund’s strategy and potential returns.

However, in 2019 this changed in the US when the Securities Exchange Commission, a US government oversight agency, brought in a new rule, allowing ETFs to become what’s called ‘semi-transparent’.

This means they either reveal their full holdings list less frequently or mask the true holdings through a representative set of securities, known as a proxy portfolio.

The products being less transparent is arguably a disadvantage for investors. While reducing transparency of the underlying holdings helps hide the full portfolio and therefore benefits the manager, it brings disclosure closer to those of funds where the full portfolio isn’t available. This is why a less transparent ETF wrapper can be more appealing to active investment managers.

Flexibility

The ETF wrapper is also perceived as offering more flexibility as it can be traded at any point during the day when the market is open.

A mutual fund can only trade once a day, so you have less insight into the exact price you’ll receive on a buy or sell.

Tax efficiency

One of the key reasons for the take-off of active ETFs in the US are that there are certain tax benefits for holding them over mutual funds.

The details of this are complex, but in essence US investors can potentially receive a better return in an ETF compared to a mutual fund, by paying less tax. This is only applicable in the US though, so doesn’t impact investors in the UK.

For UK investors, most ETFs are also domiciled outside of the UK, commonly known as ‘offshore’. This means the gains on an ETF can be taxed as income rather than capital gains. This can work for or against an investor, depending on their individual circumstances and tax allowances.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest. Remember, tax rules can change.

Growth of the active ETF market

Active ETFs in the US have slowly been increasing their market share against mutual funds. In 2022 about 63% of ETFs launched were actively managed.

Looking back further, 2021 marked the first year that more active ETFs were launched than passive (index-tracking) ETFs.

However, on our side of the pond, demand for active ETFs has been slower. European regulation still lags the US, and all the factors that previously hindered active ETFs from taking off in the US, still exist here.

That said, European appetite is growing. In 2023, of 59 professional investors surveyed, over half plan to increase their allocation to active ETFs, maintain their use or start to allocate for the first time.

What does the future look like?

Removing the need to disclose all fund holdings, along with other tax benefits has caused a surge in popularity for these products in the US. However, changes in Europe have been slow.

If regulations here are brought in line with our American counterparts, we could see a significant change in the structure of active investment products in the future. With these changes could come opportunities for investors.

Learn more about ETFs

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