How to Invest in Active ETFs

Everything you need to know about this fast-growing segment of the ETF industry.

ETF
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Reviewed by: Sean Allocca
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Edited by: Sumit Roy

ETFs used to be synonymous with passive investing. The first U.S.-listed exchange-traded funds tracked passive indexes, and for many years, the vast majority of ETFs were index-based products. Active ETFs are a small but growing force.   

That’s no longer the case. While index-based ETFs continue to dominate the broader exchange-traded fund industry, active ETFs are a small but growing force. Consider the numbers: There was $7.3 trillion invested in 3,225 U.S-listed ETFs as of Aug. 22, 2023, and of those, 2,060 were passive funds, with a combined $6.8 trillion in assets under management. 

In other words, 94% of the money invested in U.S.-listed ETFs is invested in passive ETFs. The remaining $443 billion, or 6% of total ETF assets, is invested across 1,155 active funds. 

As you can see, a relatively small share of assets in U.S.-listed ETFs is invested in active exchange-traded funds—but don’t count them out. 

Active ETFs are growing extremely fast. In 2022, they picked up nearly 15% of all exchange-traded fund inflows, according to Morningstar. And so far this year, their inflows are 25% of the total, according to data from etf.com. If active ETFs continue to generate outsized inflows, their share of the total ETF market will quickly grow. 

What Are Active ETFs? 

Before going further, it’s important to understand what active ETFs are. These funds attempt to generate higher returns than index ETFs by actively managing their portfolio holdings. Unlike index funds, which decide what to hold based on mechanical rules, active ETFs use more discretion in choosing their holdings. 

They are more flexible than index ETFs, which comes with benefits (as well as costs), which we’ll talk about later.  

There is a wide spectrum of active ETFs. Some deviate significantly from index ETFs, while others track pretty closely with indexes. The more differentiated an active ETF’s portfolio is compared to its benchmark index, the more “active share” it is said to have.  

Active ETF Types 

Active can be thought of as a type of exchange-traded fund. When you search for ETFs on etf.com, you can sort funds by whether they are active or not (more on that below). 

But the word “active” in the context of ETFs—whether a fund tracks an index or not—is a bit different than the way it’s used in other investing contexts. 

For instance, some would argue that any fund that doesn’t hold all of the stocks within a market and weights them by market value is an active fund. Those include so-called smart beta ETFs, which track indexes, but sometimes use alternative weighting schemes.  

Even outside of those, there are other index-based ETFs that use complex algorithms or ranking systems to decide which stocks to hold.  

All of those are technically index ETFs, but they might be considered “active” in some contexts. That’s not to mention that, even if an ETF tracks an index, it can be used in an active way. Many passive ETFs are used actively within portfolios—say, by short-term traders, or even long-term investors who use them tactically.  

Uphill Battle for Active ETFs 

Though active ETFs are a growing segment of the U.S. exchange-traded fund industry, many investors who use ETFs to invest have an unfavorable view of them. That poor reputation is not necessarily unwarranted. In 1991, the economist William F. Sharpe wrote a paper describing how active managers face an uphill battle. 

Passive managers “will obtain precisely the market return, before costs,” he said. But so too will the “average actively managed dollar.” And because active management is more costly than passive management, the average actively managed dollar will underperform the average passively managed dollar, he added. 

It was a simple yet profound conclusion, and one that supported the view that most investors are better off buying passive index funds than actively managed funds.  

The empirical evidence seems to support that view as well. The SPIVA scorecard, which measures the performance of active funds versus their benchmarks, reveals that active funds tend to consistently underperform. In the U.S. large cap category, for example, 87% of funds underperformed the S&P 500 over the past five years. And over the past 15 years, a whopping 93% of funds have underperformed. 

This pattern holds true across stock market categories and geographies, and even across other asset classes, like fixed income. 

In general, the longer the time horizon, the less likely it is that an actively managed fund will beat its benchmark index.  

Finding Alpha in Active ETFs 

That doesn’t mean it’s impossible for an active ETF to outperform. Though rare, some active funds manage to outperform for extended periods of time. 

This potential of generating “alpha,” or excess returns beyond what an investor can make with a passive index, is alluring, and is the reason some investors continue to flock to active ETFs despite the odds stacked against them. 

Active management tends to have a higher chance of success in some market categories, which makes funds that operate in those areas legitimate competition for index-based ETFs. 

For example, over the past decade, 32% of India’s active large cap funds outperformed the benchmark S&P BSE 100. That’s nearly one in three funds—which is no small number. 

At the same time, 42% of global income funds outperformed the Bloomberg Global Aggregate. Indeed, there’s evidence that while still more likely to underperform than not, active funds have a higher success rate in fixed income than in equities. 

The Active ETF Needle in a Haystack  

Of course, even if it’s the case that some active funds manage to outperform indexes consistently, finding the ones that do is a challenge. 

Just as an investor is likely to underperform an index by picking stocks, they are likely to underperform an index by picking active funds.  

In some ways, picking active funds is just as difficult as picking stocks. When you buy a company’s stock, you are counting on the management of that company to operate that business well and to generate attractive returns for you, the investor. 
 
Similarly, when you buy an active ETF, you are counting on the manager of that fund to operate the fund well and generate attractive returns for you. In both cases, you are depending on the skill of the manager.  

Here’s another similarity: Just because a stock has performed well in the past doesn’t mean it will continue to perform well in the future. And just because an active ETF has performed well in the past doesn’t mean it will continue to perform well in the future.  

In both cases, past performance is no guarantee of future results. 

That said, past performance can be a guide. If an active ETF has a strong track record of outperformance, that can be a signal to dig deeper. 

But other factors, such as a fund’s investment strategy, its holdings, its expense ratio and the experience of its manager(s), should be considered as well. 

etf.com has many resources to help investors find active ETFs.  

Finding Active ETFs  

The first step to find any ETF—active or otherwise—is to use etf.com’s screener. As one of etf.com’s most powerful tools, the screener allows investors to filter ETFs by myriad criteria, including asset classes, performance and geographies.  

One of the criteria is whether an ETF is active or not. You can find that filter under the “Features” tab as seen below: 
 
 

etf.com_Screener

 

Once you’ve identified a fund you are interested in, you can click on its ticker to be taken to its fund report page. 

There, you can learn more about the fund and all the key information you need to decide whether it is the right fit for your portfolio. 

Sumit Roy

Contact Sumit Roy at [email protected].

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