Passive exchange-traded funds (ETFs) aim to mirror a specific market index as closely as possible. This makes their performance relatively straightforward to evaluate — you just need to check how well they track their index and consider their costs.
Active ETFs, however, are a different story. Investment professionals actively manage these funds and make strategic decisions about buying and selling securities. As a result, evaluating their performance is a bit more nuanced than passive ETFs.
Let’s explore how you can effectively evaluate active ETFs to find the right fit for your investment portfolio and objectives.
Benchmark & Peer Comparisons
Your first step in evaluating an active ETF might be comparing it to similar funds or relevant market benchmarks. Most active ETFs focus on popular asset classes, such as core bonds or international stocks. MutualFunds.com makes these comparisons easy by grouping similar funds into categories and showing their relevant performance.
A comparison of AVUS with its category on MutualFunds.com.
Of course, returns only tell part of the story. You wouldn’t buy a car based solely on its top speed — you would look at fuel efficiency and safety features. Similarly, with active ETFs, you need to consider risks alongside returns. The result is a risk-adjusted return that offers a more complete picture of a fund’s performance across all market conditions.
The Sharpe Ratio, for instance, helps you understand how much excess return you’re getting for the extra volatility of your investment. Morningstar and other platforms make it easy to compare an active ETF’s Sharpe Ratio with that of its category, helping you determine how the risk-adjusted return compares.
The challenge is that active ETFs don’t always fit neatly into standard categories. Take the Capital Group Dividend Value ETF (CGDV) as an example. While Morningstar classifies it as a “Large Value” fund, this classification doesn’t fully capture its focus on dividend-paying stocks, which might be a key reason for investing in the fund.
Assessing Trading Costs & Fees
Active ETFs typically charge higher fees than their passive counterparts — sometimes significantly more — because they need to cover the cost of research and analysis rather than just tracking an index. Therefore, these funds need to justify these higher costs by consistently outperforming its benchmark by more than its additional expenses.
While even a 0.1% difference in expense might seem minor, it can significantly impact your returns over decades. For example, on a $100,000 investment growing at 7% annually, an additional 0.1% in costs would reduce your portfolio value by roughly $8,200 after 20 years when factoring in the actual expense and the opportunity cost.
Active ETFs also buy and sell securities more frequently than passive funds. Like putting miles on a car, high turnover usually means higher costs, affecting your returns over time. These costs often appear in the form of lower total returns that you can easily spot, but it might be helpful to understand what is dragging returns.
AVUS has 20% capital gains exposure compared to -0.3% for SPY. Source: Morningstar
Higher turnover can potentially lead to more taxable events, too. While ETFs are generally more tax-efficient than mutual funds thanks to their unique “in-kind” redemption process, it’s still worth keeping an eye on potential capital gains exposure (PCGE) — especially in taxable accounts where you’ll owe capital gains taxes.
Factoring Risk into the Equation
Active ETFs bring unique risk considerations to the table that set them apart from their passive counterparts. As you evaluate potential investments, these risks deserve special attention because their impact may not appear obvious in common risk metrics.
Concentration risk is common across many active ETF portfolios. Oftentimes, managers prefer to build focused portfolios around their high-conviction investments rather than spreading exposure across the market. While concentrating investments makes it possible to outperform, it also means you’ll have less diversification in your portfolio.
Strategy risk is another important consideration, particularly as active ETFs employ more sophisticated investment approaches. Take the JPMorgan Equity Premium Income ETF (JEPI) as an example. This fund uses options strategies to generate income — a technique that may be effective but adds a layer of complexity to the process.
Finally, manager risk plays a more significant role in active ETFs. The success of an active strategy often depends heavily on the skill and decision-making of the portfolio management team. Changes in management or strategy can impact the fund’s performance and risk profile in ways that wouldn’t affect a passive index fund.
The Bottom Line
Active ETFs can be a powerful tool in your investment portfolio, but they require a deeper understanding than their passive counterparts. While traditional metrics like performance and expense ratios matter, trading costs, tax implications, strategy risk, and other unique factors influence the performance of active ETFs, too.
