Active ETFs

Active management in an ETF wrapper

An active ETF combines two things: a portfolio manager's view and the ease of trading an ETF. You buy it on the exchange like any ETF, but inside, someone is making active choices.

In terms of cost, the product typically sits between a passive ETF and a traditional active fund: more expensive than a passive index, but often cheaper than a comparable active fund.

The distinction matters, because today an ETF is just a wrapper, not a promise of a cheap index. The same wrapper can hold an extremely cheap world index or an expensive, concentrated conviction portfolio. That's why an active ETF is assessed like an active fund, even though it's bought like a share.

The category is growing fast precisely because it combines two things: an active view and the advantages of an ETF. In the US, most newly listed ETFs today are active, especially on the fixed income side.

Alpha, beta and active share

It's worth breaking an active fund's return into parts. Beta is the part that comes from general market exposure, which you can get even with a cheap index. Alpha is the portfolio manager's genuine added value: the return that exceeds the benchmark index on a risk-adjusted basis.

On closer inspection, many “active” returns turn out to be hidden beta or extra risk taken on, not genuine skill. The key question isn't did this return more than the index, but did it return more relative to the risk taken, and is the outperformance repeatable.

Active share: how active a fund really is

Not every fund called active is actually active. Active share measures how much of the portfolio differs from the benchmark index.

The math of cost and extra return

Active management costs money, and that cost has to be earned back before you're ahead of the index. This threshold is called the hurdle.

The third row is what the portfolio manager has to earn just to break even, before the investor is a single euro ahead.

The threshold sounds small, but over decades and under uncertainty it's a high bar. The cost difference is certain; the outperformance is not. That's exactly why, in efficient large markets, a cheap index beats the vast majority of active funds.

Where active management adds the most value

In a broad, efficient stock market, it's hard for an active fund to beat a cheap index after costs. Added value is more likely where the market is less efficient or a rules-based index is a poor fit.

The most common active strategies

• Active fixed income: the portfolio manager picks bonds based on a view on credit and interest rates. The structure of the bond market is covered in the Bonds course.
• Covered call, or income ETF: sells call options and collects the premium. High ongoing cash flow in exchange for capped upside.
• Low volatility: weights stable companies and aims for smaller swings than the market.
• High-conviction and thematic: concentrates on a few companies. The highest chance of extra return and the biggest swings.

Transparency and tax treatment

A classic ETF publishes its holdings daily. An active portfolio manager doesn't always want to reveal their moves in real time, because others can exploit the information. That's why semi-transparent structures have emerged, which report holdings with a delay or partially.

Even a semi-transparent structure is regulated. What matters more than how often holdings are published is whether you understand the strategy and where the return is meant to come from.

The past-performance trap

Choosing based on past success is deceptive. Research shows that yesterday's winners are rarely tomorrow's winners: outperformance tends not to persist.

On top of that, statistics are distorted by survivorship bias: poorly performing funds are closed and disappear from comparisons, which leaves an overly rosy picture on average. A good run of a few years can be skill or pure luck.

When is active management worth paying for?

Active management always costs something. The question is whether you get value for it. It can be justified especially in markets where the index is clumsy or hard to implement, for example in parts of the bond market or in emerging markets.

• What is the active management aimed at? Stock selection, allocation or risk management?
• How much does it cost? Compare the ongoing charges with a comparable passive alternative.
• How much does it differ from the index? If the deviation is small, you're paying for active management without getting it.
• Is the process understandable? If you can't explain the strategy, you can't assess it.

How to assess an active ETF

• Source of return: where is the outperformance meant to come from, and is that credible?
• Active share: does the portfolio genuinely differ from the index?
• Cost vs. index: is the hurdle realistic in this particular market?
• Market: is this an inefficient market where active management can pay off?
• Track record and team: a long enough history, the same team, experience of different market conditions?
• Role in the portfolio: a complement, not the core; at most a considered satellite.

For most people, a cheap, broad index ETF is still the most natural core of the portfolio. An active ETF fits where you believe a view adds genuine value, and you're prepared to pay for it. Don't buy active management just because it sounds more sophisticated.

This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns. The calculators and comparisons are illustrative.