Is Launching an Actively Managed ETF Right for Your Investment Strategy?

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Interest in actively managed ETFs (exchange-traded funds) continues to grow as investors and financial advisers gravitate towards these structures as an investment of choice.  According to FactSet, U.S. ETFs recorded inflows of over $90 billion in 2021 with total ETF assets exceeding $7.2 trillion¹. Active ETFs accounted for 10% of all ETF inflows despite being only 4% of total ETF assets and 60% of active ETFs flows in 2021 went to ETFs that had higher expense ratios than the industry average of .49 bps², showing investor willingness to pay more for brand name and proven performance. Industry analysts believe this growth is expected to continue as many investors value an active investment strategy in an ETF wrapper.

Before an investment manager considers launching an Actively Managed ETF, there are a number of informational items to know about them. In this blog we will:

  • Define actively managed ETFs
  • Describe the core workings of an ETF
  • Explain the difference between actively managed ETFs and traditional ETFs, and mutual funds
  • Explore the advantages of actively managed ETFs
  • Explain why advisers are seeking actively managed ETFs for their investor portfolios

What Is an Actively Managed ETF?

Actively managed ETFs aim to achieve a specific investment objective by employing an active investment strategy rather than a passively managed ETF that looks to track an index. Its underlying portfolio is determined by a manager or team instead of following a passive investment strategy. Although an actively managed ETF will have a benchmark index, fund managers can adjust sector allocations and diverge from the index as they see fit. This results in investment returns that may deviate from the underlying index.

Actively managed ETFs are available in some of the following asset classes:

  • Domestic and Global Equity
  • Domestic and Global Fixed Income
  • Asset Allocation
  • Currency
  • Commodities
  • Alternatives

 Core Workings of ETFs

Actively managed ETFs are typically registered under the Investment Company Act of 1940 as open-end funds. An ETF provider creates a fund based on their particular investment strategy and issues shares of that fund to the marketplace in creation units through registered broker-dealers know as Authorized Participants (APs). The ETF’s shares are listed on a national securities exchange, and individual investors trade the ETF like a stock at market prices during the trading day as compared to a mutual fund which trade once a day at net asset value (NAV), which is determined at the end of the trading day.

How Do Actively Managed ETFs Differ from Traditional ETFs?

Actively Managed ETFs invest in strategies implemented and followed at the discretion of a portfolio manager and the firm’s proprietary research. Most traditional ETFs are structured as passively managed funds designed to track an underlying benchmark as closely as possible (ex: the S&P 500 Index). Actively managed ETFs take a more hands-on investment approach, where their portfolios are generally more concentrated in securities that are expected to outperform. 

Unlike their index-based competitors, actively managed portfolios do not follow a predictable rebalancing method, keeping in mind that it’s up to the portfolio manager to keep the active portfolio invested according to its stated purpose. Hence, investors wanting core exposure to an asset class may consider a passive ETF. Those wishing to supplement current holdings may consider an actively managed fund with the potential to outperform the market. 

Mutual Funds vs. Actively Managed ETFs

Actively managed ETFs are similar to actively managed mutual funds in that both are likely to have higher compositional turnover than their indexed counterparts, and professional money managers play a crucial role in deciding which holdings to invest in. They also provide exposure to various asset classes and specialty markets. However, while both aim to outperform the market and rely on active managers to select which stocks and bonds to hold, they differ in some key areas. 

Active ETF shares trade like stocks and can be traded throughout the day as often as needed. On the other hand, mutual funds only trade once a day when markets close.

Transparent active ETFs are required to publish their portfolio holdings daily vs a mutual fund that discloses holdings quarterly with a lag period of 60 days. Active ETFs are typically more tax efficient due to the in-kind trading for creation and redemptions of shares. Mutual funds create and redeem shares in cash and generate taxable gains and losses which typically result in capital gains distributions to the shareholders. 

Active managers who are concerned with the daily disclosure of portfolio holdings requirement for transparent active ETFs, can consider various semi-transparent/non-transparent structures that are currently available to ETF sponsors. Semi-transparent ETFs are actively managed exchange-traded funds that shield the actual daily holdings while fully disclosing their holdings quarterly. This may provide portfolio managers a chance to use their strategies in cheaper alternatives to mutual funds without running the risk of being copied or front-running of specific securities.The semi-transparent models that are approved by the SEC do vary and interested fund sponsors should carefully consider the benefits and limitations of each product when considering if it is the right fit for the intended investment strategy.

Advantages of an Actively Managed ETF for Individual Investors

Tax efficiency is one of the most significant benefits of an actively managed ETF. Due to the in-kind nature of creations and redemptions, actively managed ETFs have fewer taxable events than mutual funds. On the other hand, investors of mutual funds with similar investment strategies and shareholder activity are typically subjected higher capital gains distributions, depending upon the turnover of the fund portfolio. Investors should not expect that an active ETF will never have a capital gain distribution. Given consistent market conditions and shareholder activity, an active ETF can expect to distribute higher capital gains compared to a passive ETF but it is anticipated that the active ETF’s capital gain distribution would be lower than a mutual fund with the same investment objective. 

Other advantages of actively managed ETFs include:

  • Lower expense ratio.
  • Participation of seasoned financial professionals.
  • The opportunity for benchmark-beating returns.
  • Ability to trade ETF shares throughout the day.

Why Are More Advisers Seeking Managed ETF Portfolios?

Exchange-traded funds continue to be a favorite investment instrument for investment advisers due to their unique characteristics. While ETFs’ tax advantages, a lower management fee, and intraday liquidity are well known, incorporating them into a managed portfolio is one of the fastest expanding strategies in the managed investment fund sector. Investment advisers are employing managed ETF portfolios to manage risk more efficiently, in addition to taking advantage of the inherent ETF efficiency.

Furthermore, some actively managed ETF portfolios offer cutting-edge methods that lend themselves to a quantitative investment strategy. Regardless of financial goals, the ability to trade ETFs within a managed portfolio allows investors to be flexible and take advantage of opportunities that regular mutual fund investors may not receive. 

Conclusion

ETFs are growing at ever-increasing rates. With recent industry changes that streamline the regulatory process to launch an ETF, investment managers are expanding their product offerings to attract additional investors. There’s a myriad of nuances to be aware of and we have explored and explained a number of these considerations in this blog. As ETFs continue to gain significant investment flows, if you are interested in launching an ETF, consider working with an experienced fund administrator to help you understand the ETF ecosystem and distinctions of Actively Managed ETFs.

At Ultimus Fund Solutions, we believe in providing a consultative approach, helping investment managers understand a product’s nuances and operational considerations before launching a fund. Contact us today for a consultation about whether bringing an Actively Managed ETF to market is the right product for you and your business.  

15070303 5/25/2022

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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