The introduction of active ETF products has allowed for greater flexibility in portfolio management and the potential for alpha generation in the ETF space, addressing the demands of investors seeking more tailored investment strategies.
In addition, in the past decade, active ETFs have experienced significant growth, with issuers expanding and diversifying their offerings into new asset classes, including fixed income and alternatives.
Investor adoption of active ETFs, meanwhile, has been fuelled by their transparent nature, lower cost — especially when compared with traditionally actively managed funds — and their tax efficiency in certain regions, helping cement their value proposition for modern-day investment portfolios.
Comparing active ETFs with open-ended funds
It may be no surprise that there has been a meteoric rise in active ETFs. According to Oliver Wyman, from 2016 to 2022, the number of active ETFs launched increased by 30 per cent a year in the US and 92 per cent a year in Europe, as the European market tried to match the growing demand of investors and to catch up with the US’s lead in active ETFs.
Despite this growth, active ETFs make up only a small portion of open-ended funds, with roughly 10 per cent of the total ETF market and just 0.3 per cent of the open-ended fund market as of 2023.
Clearly, there is room to run in terms of continued growth in this segment of the market fuelled by the transparency, efficiency and accessibility — and typically, lower cost — of ETFs compared with traditional funds, which have driven their popularity among individual and institutional investors alike.
Creation and redemption mechanism:
- ETF’s unique creation and redemption mechanism involves large financial institutions known as authorised participants that can create new ETF shares by delivering the underlying assets to the ETF provider or redeem ETF shares in exchange for the underlying assets. This process helps keep the ETF’s market price close to its net asset value and ensures that liquidity is maintained, even for ETFs that might not have as much trading volume.
- The ability of APs to directly create or redeem shares of the ETF in exchange for the underlying securities ensures that the ETF can accommodate large trades without significantly impacting the market price. This mechanism helps maintain liquidity and makes ETFs attractive for both retail and institutional investors.
Liquidity:
- Investors themselves can buy or sell ETF shares at market prices at any time during trading hours, much like stocks. This ability to trade intraday enhances liquidity, allowing for quick entry and exit from positions.
- Furthermore, ETF investors can use various types of orders, such as market orders, limit orders and stop orders, to execute trades. This flexibility helps investors manage their investment more precisely and contributes to the liquidity of ETFs.
Cost efficiency:
- In addition to typical lower fees, the tax advantages and savings of ETFs can be very impactful relative to open-ended funds. The in-kind exchanges noted above eliminate trading-related capital gains or losses. Non-transacting shareholders of funds bear the trading costs and commissions that stem from net flows into and out of funds, which is not the case for ETFs.
- Cash drag can be detrimental to performance in open-ended funds. On average, funds hold large amounts of cash in order to meet anticipated redemptions. Due to in-kind creation and redemptions for ETFs, the products do not need to hold an outsized allocation to cash and can invest more directly in the intended portfolio strategy.
Transparency:
- ETFs are highly transparent within the financial services industry. Regulators require daily disclosure of ETF holdings and position sizes, ETF NAV is updated every 15 seconds during market hours, and ETF investors have almost instant access to portfolio holdings. For this reason, ETFs allow real-time analysis and management of risks, exposures and taxes.
- In contrast, open-ended fund shareholders lack control over real-time investment adjustments and must wait 30 days post-quarter for full holdings information. Timely information access in ETFs contrasts with the delayed information in funds, leading to significant differences in asset management.
Thematic nature of active ETFs
The ETF vehicle lends itself well to active strategies that are focused on providing thematic exposure. Disruptive innovation is a prime example of a thematic exposure that is hard to capture in a traditional passive strategy. This includes innovation platforms such as artificial intelligence, robotics, energy storage, blockchain technology and multiomics.
Common benchmarks often do not capture names involved in pure play innovation and may fail to align with the adaptive nature of these themes, and by deploying an active strategy investors are able to access the market in differentiated ways, enumerated below:
Actively selecting winners/avoiding losers:
- Not all companies in the innovation space will be winners, and the success of disruptive technologies can be uneven. Active management allows investors to invest selectively and uncompromisingly in companies with the strongest fundamentals, most innovative products and best growth prospects, rather than being tied to the performance of an equity benchmark — for example, the S&P 500 index. Importantly, many of the most disruptive companies fall outside standard equity benchmarks due to their smaller size or lack of investment coverage.
Opportunistic agility and risk management:
- Active management allows fund managers to adjust portfolios quickly in response to technological advancements, industry news and company announcements. The landscape of disruptive innovation moves swiftly, with new technologies evolving and market dynamics shifting at a rapid pace. Active management affords investors the flexibility to capitalise on opportunities and mitigate risks as they arise.
Bypassing the market’s short-term horizon:
- The market is often easily distracted by short-term price movements, losing focus on the long termism of investing in disruptive technologies. We believe there is a time arbitrage in line with Amara’s Law, which states that humans tend to overestimate the effect of a technology in the short term and underestimate its effects in the long run. Accordingly, investors can seek out opportunities that offer growth, and which the market is often not focused on.
Expertise and insight:
- Active management allows for the leveraging of specialised knowledge and research. Domain expertise can be crucial for technologically nuanced areas spanning from AI to multiomic sequencing.
Purity-weighted indices — those whose methodology focuses on capturing the theme beyond simply weighting stocks by market capitalisation — may also be an appropriate method to capture niche themes in a diversified manner. However, active strategies give the added ability to apply dynamism in capturing portfolio exposures and reacting to market developments.
