The rise of active ETFs – what are they and what does the future look like?

An ETF is a basket of investments that includes investments like shares and bonds. Traditional ETFs generally aim to track a benchmark, like the S&P 500 or FTSE All Share. They’re generally known for their low-cost, passive approach. The price of an ETF will vary depending on the value of the underlying investments.

Investors might be familiar with managers using mutual funds for active or passive fund management, like many of the funds seen 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.

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

Why are they becoming so popular?

Active ETFs have always been possible, but they previously required managers to publish the full portfolio breakdown every day. For many 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 portfolio can remain a secret to the public, which is one of the reasons why they’re popular.

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

However, in 2019 this all changed thanks to the securities exchange commission (SEC), a U.S. government oversight agency whose aim is to protect investors by maintaining fair, orderly and efficient markets. They brought in a new rule specific to the U.S., allowing ETFs to become what’s called ‘semi-transparent’. This means they either reveal their portfolios less frequently or mask the true holdings through a representative set of securities, known as a proxy.

Why don’t active managers just stick with mutual funds?

All things equal, one of the biggest benefits for using an ETF structure over a mutual fund is lower annual management charges. Mutual funds will spend money on things like marketing, distribution, and trading – increasing costs for investors. ETFs on the other hand either won’t spend money on these costs, or they will be much lower. Other charges like dealing and platform costs often apply, so it’s important to factor these in too.

The way ETFs are traded also offers some tax benefits. When investors buy mutual fund units, they provide cash to portfolio managers who then buy a selection of investments. When investors sell mutual fund units, portfolio managers often need to sell investments to come up with the cash to facilitate that sale. This cash in/out process can be costly, resulting in trading costs and tax bills.

Whereas, when an investor wants to buy or sell an ETF, they simply trade it like a share. This means there’s no need to deal in the underlying investments, and so no capital gains transaction for the ETF as well as avoiding certain trading costs on purchases. Tax rules can change and benefits depend on personal circumstances.

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.

Growth of the active ETF market

Since the SEC changes, active ETFs in the U.S. have slowly been increasing their market share versus mutual funds. In 2021 about 60% of the nearly 500 ETFs that launched in the US were actively managed. This marks the first year that more active ETFs were launched than passive (index-tracking) ETFs.

Last year also marks the first time active mutual funds have converted to an ETF wrapper.

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, a recent global ETF survey showed European appetite for these products is growing. This survey accounts for more than 60 executives around the world in 2021, and the participating firms cover over 80% of global ETF assets. The report suggests demand for active ETFs across several regions is set to increase within the next two to three years, with most regions other than Asia-Pacific seeing an increase in demand.

Source: PwC 2021 Global ETF Survey

Half of the participants in the survey also indicated they would launch a semi-transparent active ETF in the next two to three years if the transparency rules changed.

What does the future look like?

Removing the need to disclose the portfolio holdings along with other benefits has caused a surge in popularity for these products in the US. But 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 even more opportunities for investors.

To learn more about ETFs and their charges, visit our Help & Support page.

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