Exchange-traded funds (ETFs) have become incredibly popular over the past decade. After 2020’s record $500 billion in inflows, ETFs raked in more than $900 billion in 2021 with nearly 450 new ETF launches. While the $7 trillion industry is still smaller than the $20 trillion mutual fund business, the rise of actively-managed ETFs could close the gap.
Let’s take a look at the differences between active and passive ETFs, how to determine what category a fund falls under, and how new funds are blurring the line between the two strategies.
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Active vs. Passive ETFs
Most investors are familiar with active and passive strategies. Active strategies involve asset managers selecting investments, whereas passive investments track an underlying index, such as the S&P 500. While most research suggests active strategies tend to underperform the market, they have experienced a renaissance in recent years.
Two-thirds of ETF launches last year were actively-managed funds, including several from mutual fund giants, like T. Rowe Price and American Century. Many of these more prominent fund managers were drawn into the fold by the SEC’s move to allow semi-transparent active ETFs, or ANTs, enabling them to avoid daily disclosure rules.
How to Tell the Difference
The easiest way to determine if an ETF is active or passive is to read the prospectus. For example, the ARK Innovation ETF (ARKK) summary prospectus says that it’s an “actively-managed exchange-traded fund” in the “Principal Investment Strategies” section on the first page. Simply scanning the prospectus for the word ‘active’ may be sufficient.
Active prospectuses also typically highlight investment strategies, like finding ‘undervalued securities’ or using a ‘bottom-up’ approach. For example, a PIMCO active ETF prospectus says, “PIMCO will utilize a bottom-up approach to seek to identify asset classes and securities that are undervalued,” which suggests an active approach.
The final tell-tale sign of an active ETF is the lack of an underlying index. While active ETFs may mention benchmark indices, they will never have an underlying index since investment managers select the assets. That said, some strategies blur the line between active and passive because they use underlying indexes, as we’ll see next.
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Blurring Active and Passive
The techniques we’ve covered can help you determine if an ETF is active or passive, but it can still be difficult to tell in some cases. In particular, smart beta ETFs use proprietary indexes weighted by factors other than market capitalization. One could argue that these indexes essentially automate stock picking, making them more active than passive.
For example, the First Trust Large Cap Core AlphaDEX ETF (FEX) tracks the Defined Large Cap Core Index. The index is a subset of the S&P 500 that weights components based on growth and value factors, such as sales growth and book value. The bottom 25% of companies are eliminated, and the top 75% create the underlying index.
However, the most ambiguous examples are ETFs leveraging black box indexes. For example, the Invesco Raymond James SB-1 Equity ETF (RYJ) tracks an underlying Raymond James SB-1 Equity Index, consisting of equities rated “Strong Buy 1” by Raymond James. These ratings reflect proprietary quantitative and qualitative factors.
The Bottom Line
Active ETFs have become increasingly popular over the past few years. While these mutual funds still eclipse ETFs, the rise of actively-managed ETFs could close the gap over the coming years. Meanwhile, the lines between passive and active funds are likely to become increasingly blurrier over time as funds adopt novel strategies.
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