Exchange traded funds are generally associated with passive investing. But there are now nearly 500 actively managed ETFs, and some have performed exceptionally well recently.
This post examines the differences between active and passive ETFs, and whether the universe of actively managed ETFs is likely to expand further.
- Active vs. passive ETFs
- Active ETFs vs. mutual funds
- The case for active ETFs
- ARK Invest ETFs
- Other active ETFs
- Risks of investing in actively managed ETFs
- Future of active ETFs
Active vs. passive ETFs
Most of the exchange traded funds currently available to investors are managed passively. These funds simply replicate an index of securities or other assets. Changes are only made when the index itself is rebalanced. This typically occurs on a quarterly basis.
While the goal for index ETFs is to track a benchmark index as closely as possible, the goal for actively managed ETFs is to outperform the benchmark index. Active ETFs are managed by a portfolio manager or a team of fund managers and analysts. Decisions regarding the investment strategy, stock picking and asset allocation can be made as often as on a daily basis. Both passively and actively managed ETFs can be constructed to offer exposure to broad investment strategies like growth or value investing and across various asset classes.
However, some investment themes and strategies are better aligned with either active or passive mandates. Passive investing is better suited to quantitative strategies like factor investing, smart beta, and systematic investing. Active investing is better suited to strategies that require qualitative decision making. This is often the case with fundamental analysis, ESG investing and investing in companies that are not yet cash flow positive. Active strategies are also well suited when indexes aren’t as meaningful. This is the reason most actively managed ETFs invest in fixed income securities.
The major advantage of passively managed ETFs is that they enable investors to earn beta while paying low management fees. The advantage of actively managed ETFs is that they can generate alpha, though there is no guarantee that they will. However, more resources are required to manage active ETFs, and so they have significantly higher expense ratios.
Active ETFs vs. mutual funds
Actively managed ETFs are managed in a similar manner to most mutual funds, apart from index tracker mutual funds. However, unlike mutual funds, active ETFs are traded on exchanges like shares. They are bought and sold at a price determined by supply and demand, rather than at the NAV of the fund.
Actively managed ETFs and mutual funds serve a similar purpose. But there is a distinct advantage to ETFs in that one trading account gives an investor access to any fund listed on a stock exchange. Investing in mutual funds requires a separate account with each provider, or with a fund platform that may offer a limited range of funds.
The case for active ETFs
The majority of index funds track indices that are weighted by market cap. These funds have enjoyed a unique set of circumstances over the last 10 to 15 years. The bull market of the last decade or so has been led by large cap growth stocks, like Amazon, Apple, and Microsoft. As these stocks have grown, their influence on market cap weighted indexes has increased. The result has been particularly good environment for ETF investing with passive funds.
The majority of actively managed portfolios had historically a value investing bias. Value investing has underperformed in recent years, partly due to the combination of disruptive technology and low interest rates. So, while market conditions have favored index investing, they have been a challenge for active managers.
If the investment environment changes, and there are some indications that it is, market cap weighted indexes could be heavily weighted to underperforming stocks and have low exposure to outperforming stocks. This would favor active managers and those with a bias toward value stocks and cyclical stocks.
Investments in stocks that turn out to be multibagger stocks are typically made when the company still has a low market value. By the time these stocks are included in a market index, the biggest gains have already been made. Active managers are free to take meaningful stakes in smaller companies.
Passive investing has risen in prominence since 2005. During this period there have only been two substantial bear markets, and both were relatively short lived. If the market experiences a secular bear market that lasts longer, active managers may be in a better position to navigate such an environment. Fund managers who are skilled at market timing and interpreting investment warning signs would be well positioned to deal with a protracted bear market.
ARK Invest ETFs
ARK Invest has arguably been the most successful manager of active ETFs. The company currently manages the six largest active equity ETFs in the world. ARK was founded by Cathie Wood in 2014 and already manages $50 billion in assets. ARK Invest focusses on investing in companies building disruptive technology and software. Specific areas of focus include electric vehicles and other types of automation, artificial intelligence, healthcare technology and fintech. These industries are all participating in the megatrends reshaping the global economy.
The company’s success arguably has as much to do with its sectors and industries of focus than on stock picking or portfolio management. Nevertheless, the company has made some remarkably successful stock picks over the last few years.
- ARK Innovation ETF (ARKK) – The flagship ARK fund invests in companies engaged in disruptive innovation. Notable holdings include Tesla, Square, Teladoc, and Roku. These are all companies that are disrupting industries with technology. The fund has returns 538% over the past five years and 144% over the last 12 months. The fund currently has AUM (assets under management) of nearly $24 billion.
- ARK Genomic Revolution ETF (ARKG) – ARK’s second largest fund invests in companies engaged in gene editing, genetic therapy, molecular diagnostics, and stem cell science. Investing in these industries requires very specific knowledge and skills, and it makes sense to employ an active approach. The fund’s largest holdings include Teladoc Health, Exact Sciences, Regeneron Pharmaceuticals and Pacific Biosciences. This fund has $9 billion in AUM. The fund has returned 129% over the last 12 months and 417% over the last five years.
- ARK Next Generation Internet ETF (ARKW) – ARK’s other large ETF, with AUM of $6.7 billion, is a more general fund that invests in companies in any industry associated with the internet. The industries include cloud computing, e-commerce, big data, artificial intelligence, mobile technology, social platforms, and financial technology. The universe is quite loosely defined with the result that the largest holding is Tesla. Other notable holdings are Square, Grayscale Bitcoin Trust, Roku, Spotify, and Shopify. The fund has returned 142% over the last 12 months and 692% over five years.
The other ARK ETFs focus on fintech, industrial innovation, space exploration, 3D printing and Israeli tech stocks. The funds all have expense ratios of between 0.49 and 0.79%. These are a lot higher than index funds, but reasonable when compared to actively managed mutual funds.
Other active ETFs
The vast majority of actively managed ETFs are bond funds, but there is a growing number of equity funds and multi-asset funds. These are just a few of the prominent active ETFs:
- Amplify Transformational Data Sharing ETF (BLOK) – One of the largest active equity ETFs is this Amplify fund which invests in companies with exposure to blockchain technology and cryptocurrencies. The fund’s largest holding is MicroStrategy, a company that holds 90,000 Bitcoins on its balance sheet. Other holdings include PayPal, Square, Galaxy Digital Holdings Ltd, and Nvidia. The fund has around $1 billion in AUM. This is more a function of the fact that there are very few other ways to invest in cryptocurrencies via the stock market. Nevertheless, the ETF has generated returns of 183% since inception three years ago and 213% in the last year.
- First Trust Long / Short Equity ETF (FTLS) – As the name implies, the First Trust Long / Short fund holds long and short equity positions. The objective of this portfolio hedging strategy is reduce volatility and generate positive returns over the long term. The fund holds long positions worth 80 to 100% of the value of the fund, hedged with short positions worth 0 to 50% of the fund’s value. This ETF has AUM of $330 million and has a relatively high expense ratio of 1.6%. The fund has returned 19% over the last 12 months and 50.6% over five years.
- Avantis U.S. Small Cap Value ETF (AVUV) – American Century Investments manages several active ETFs including the Avantis Small Cap Value fund. Small Cap stocks are better suited to active management due to the increased risk. The fund’s largest holdings are Cimarex Energy Co, Louisiana-Pacific Corporation and Targa Resources Corp which operate in the energy and resources sectors. These stocks all have market values lower than $10 billion. The fund was launched in 2019 and has returned 125% over the last 12 months. This impressive performance, along with the relatively low expense ratio of 0.25% has attracted assets of $1 billion already.
- Main Sector Rotation ETF (SECT) – Main Management’s sector rotation fund is a fund of funds that rotates between sector ETFs. The objective is to outperform the S&P500 during bull markets and limit downside during bear markets. The fund has managed an impressive 61% return over the last year and charges 0.8% in annual fees. The fund has AUM of $799 million.
- AdvisorShares Pure US Cannabis ETF (MSOS) – The advisor shares Pure US Cannabis fund was only launched in September last year, but already has nearly $1 billion under management. This is no doubt due to the attention the US cannabis industry has attracted since the election in November. The largest holdings in the fund are Green Thumb Industries, Cresco Labs and Curaleaf. The fund has generated a 51% return over the last six months.
- Vanguard U.S. Value Factor ETF (VFVA) – Vanguard launched the world’s first index fund and remains the second largest ETF manager. The company has now leveraged its fund management resources to launch a low-cost active ETF. The fund is actively managed but clearly draws from the Vanguard’s extensive quantitative research on factors. Prominent holdings include blue-chip growth stocks like AT&T, Verizon, and CVS Health. The fund was launched in 2018 and generated a 98% return over the last year. This is particularly impressive when one considers the 0.14% expense ratio.
- First Trust Preferred Securities and Income ETF (FPE) – This First Trust ETF earns income for investors with a dividend investing strategy. The fund invests in preferred shares with good yields and convertible bonds. This enables the fund to generate capital gains as well as income. The funds has $6 billion under management and currently yields 4.7%. It has also generated capital gains of 23% over 12 months and 42% over 5 years.
- SPDR DoubleLine Total Return Tactical ETF (TOTL) – The SPDR DoubleLine fund is a popular bond ETF managed by Jeffrey Gundlach, one of the fixed income world’s best investors of all time. The fund invests in bonds issued by governments around the world, corporate and mortgage bonds, and other debt instruments. The fund has returned 3.19% over the last 12 months and 13.48% over 5 years.
- RPAR Risk Parity ETF (RPAR) – This multi-asset class ETF is managed by Advanced Research Investment Solutions. The fund holds bonds, equities, commodity ETFs, and currencies to reduce portfolio risk and volatility. This is a strategy popularized by Ray Dalio at Bridgewater Capital. The ETF was launched in December 2019 and has AUM of $1.2 billion. Over the last 12 months the fund has returned 16.9%.
Risks of investing in actively managed ETFs
In most respects actively managed ETFs can be compared to actively managed mutual funds. With any actively managed product, the biggest risk is that investors often chase performance. Very often the best performing funds in the short term are those that invest in specific types of stocks, or with a specific investment style. Investors are often tempted by historical returns that are difficult to repeat.
To get an accurate idea of a fund’s long-term potential, you need a longer track record. Ideally the track record should include periods of volatility and bear markets too. In the absence of a longer track record, the fund manager’s track record and the management company itself needs to be evaluated.
Morningstar recently pointed out that the ARK Invest funds carry considerable risk because they own large stakes in some companies. In the event of a stock market crash leading to redemptions, the fund itself would put pressure on the prices of those stocks. They also pointed out that the team is inexperienced and risk controls are lax. This doesn’t mean ARK investment funds aren’t a good investment, but they should not be treated as low-risk investments.
Future of active ETFs
Whether or not actively managed ETFs outperform in the future will depend on two things. Firstly, if market conditions no longer favor the largest stocks in indexes like the S&P500, it will be easier for active managers to generate alpha. The other factor concerns the way the fund’s themselves are managed.
As a group, actively managed funds have underperformed their benchmarks over the long term. If active ETFs are managed in the same way, there will probably be a few that stand out, while most underperform. However, we may see new approaches to active management that result in better performance.
If a new era of active management emerges it will probably leverage the power of artificial intelligence, big data, sentiment analysis and alternative financial data. Investment funds like the LI Data Intelligence Fund or the LI Data Intelligence Fund German Equities are already leveraging these technology led approaches, which are increasingly finding their way into mainstream fund management.
Market liquidity is better than it’s ever been, and trading costs are the lowest they have ever been. This means a more active trading strategy that wasn’t viable in the past may now offer an edge. It’s entirely possible that some actively managed ETFs will be very actively managed.
Conclusion: Investing in actively managed ETFs
If active ETFs manage to outperform indexes in the next few years, we will probably see a lot more of them in the market. They may also displace mutual funds as the investment vehicle of choice for active managers. Active managers will also need to perform better than actively managed mutual funds have in the past. No doubt there will be some successful funds, but whether or not the industry can reverse the flow to passive funds remains to be seen.