What Are Actively Managed ETFs and Do They Work?

When most investors think of exchange-traded funds (ETFs), they think of passive investing strategies. These funds track a wide variety of indexes and sport low turnover and cost as well as high diversification opportunities.

Passive investing has become a favored method for investors of all stripes, as analysts cite studies showing that passive strategies tend to win out overactive ones in the long term. Nonetheless, there are also actively managed ETFs, although they tend to slip under the radar.

Despite the fact that only a minority of actively managed funds will beat the market, some investors are interested in pursuing these larger profit goals. In this way, the design of ETFs can help the active investor strategy as well. ETFs allow intraday trading; this is in opposition to mutual funds, which trade just once per day. With intraday trading, ETF investors have the chance to track the direction of the market and make trades within the day accordingly, thereby aiming to take advantage of short-term shifts.

Actively Managed ETFs

The most common ETF design tracks a particular index. However, ETFs can also be built to track the top picks of an investment manager or a mutual fund, for example. In this way, these ETFs would mimic an actively managed strategy. They would also aim to provide above-average returns. ETFs that are actively managed can also provide a benefit to mutual fund investors and to fund managers, too.

An ETF that tracks a mutual fund, for example, will likely appeal to frequent traders over the mutual fund itself as a result of the intraday trading capabilities. Thus, with trades focused on the ETF, the mutual fund is less likely to experience cash flow in and out, and the portfolio is likely to be easier to manage and increasingly cost-effective.

Trends in the ETF Space

Traditional, passively managed ETFs still vastly outnumber actively managed ETFs. In the U.S. there are approximately 500 actively traded ETFs, which accounts for about 20% of all ETFs. Together, active ETFs constitute only $172.8 billion of the $5.92 trillion ETF space. However, investor interest in the active ETF category has prompted major growth in this area, and it's likely that this trend will continue.

By year-end 2020, the assets under management (AUM) for active ETFs increased by 71% over the previous year. About 50% of all new ETFs launched in 2020 were actively managed and the implied active ETF revenue nearly doubled over the previous year, coming in at over $600 million. This growth in actively managed ETFs occurred over several asset classes, including domestic and international fixed income, international equity, and commodities.

Active ETFs have even become so popular as to inspire some passive ETFs to include the word "active" in product descriptions and names, even if that term doesn't accurately reflect the strategy of the ETF itself. Investors are thus cautioned to remain vigilant in their research before investing in a product.

Benefits and Risks

Why invest in an active ETF over a mutual fund, for instance, or another related product? Aside from the benefits of intraday trading, many actively managed ETFs have lower expense ratios than their comparable mutual fund equivalents. They may be cheaper to purchase, depending upon the broker involved. Additionally, some actively managed funds can see exponential growth, particularly those that focus on a specific sector or trend.

For example, ARK Innovation ETF (ARKK) surged 147.7% in 2020. The active equity ETF, founded in Oct. 2014, focuses on "disruptive innovation." The fund holds companies that are at the forefront of technological and scientific advancements. This includes everything from DNA technology firms, industrial innovators, next-generation Internet companies, and fintech service providers.

That's not to say that actively managed ETFs aren't without risks. ARKK's theme of disruptive innovation did well during the pandemic crisis of 2020 when its holdings in Tesla, Teladoc Health, and Zoom Video Communications surged. It appears active strategies may do better during times of high market volatility, while passive strategies tend to outperform when markets exhibit a higher degree of correlation.

Research still suggests that passive strategies are more effective than active ones over a long period of time. Nonetheless, active ETFs seem to be building momentum within the investor community.