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DEFINITION of 'Actively Managed ETF '

An actively managed ETF is a form of exchange-traded fund that has a manager or team making decisions on the underlying portfolio allocation, otherwise not adhering to a passive investment strategy. An actively managed ETF will have a benchmark index, but managers may change sector allocations, market-time trades or deviate from the index as they see fit. This produces investment returns that do not perfectly mirror the underlying index.

BREAKING DOWN 'Actively Managed ETF '

An actively managed ETF features many of the same benefits of a traditional exchange-traded fund like price, transparency, liquidly and tax efficient, but with a fund manager that can adapt the fund to changing market conditions. The combination of active management and an ETF provides investors with an innovative solution to asset management. For investors, there is enough to like about active ETFs; lower expense ratios than mutual funds, active participation of seasoned financial professionals, and the opportunity to gain benchmark-beating returns. 

It's not certain that an actively managed fund will under- or outperform a passive-ETF rival, though. Traditional ETFs can at least be counted on to follow an index faithfully, which allows investors to know the holdings and risk profile of the fund. This helps keep a diversified portfolio in line with expectations. Fund managers of an active ETF, however, have the freedom to trade outside of a benchmark index, which makes it more difficult for investors to anticipate the future makeup of the portfolio. This can work for investors when market conditions experience heavy volatility. An active manager can shift allocations away from underperforming positions to more appropriate sectors or asset classes. 

In late 2017, asset management giant Vanguard announced plans to roll out a catalog of active managed ETFs. The move is a sharp departure from the index-based strategy championed by founder John Bogle for multiple decades. 

Limitations of an Actively Managed ETF

Although actively managed ETFs share many of the same characteristics of traditional exchange-traded funds, they tend to come at a premium. Many of them have higher expense ratios than a traditional index ETF, which puts pressure on fund managers to consistently outperform or beat the market.

As with a mutual fund, the potential to outperform comes down to the underlying manager. Some will regularly beat expectations, but most research finds active management to underperform a passive strategy. Furthermore, actively managed ETFs tend to contradict basic investment principles like diversification. The typical fund manager shifts allocations according to market conditions, meaning the fund may be less diversified than a passive ETF.

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