The popularity of exchange traded funds (ETFs) has exploded over the years as investors have discovered their benefits on a number of fronts. Intraday tradability, diversification, potential tax savings, and low costs are just some of the hallmarks of the fund type.
However, not all ETFs are structured the same way or passively managed. In fact, there are now numerous active ETFs on the market that offer investors a chance to build their portfolios and meet their goals.
But even here, it’s not a cut and dried decision. Active ETFs come in two flavors: Fully Active and Smart-Beta.
For investors, understanding the difference between the two flavors of active ETFs is important when constructing a portfolio. Their differences matter and can produce widely different results even when looking at the same asset class. Understanding how they work differently can ultimately help you build a better portfolio and meet your financial goals.
Be sure to explore our Active ETFs Channel to learn more about them.
A Different Approach
While the roots of the ETF revolution started in 1989, the first real ‘ETF’ to successfully launch was the SPDR S&P 500 ETF Trust (SPY). The fund allowed investors to trade all the stocks in the S&P 500 and tracked the benchmark index. The SPDR (Standard and Poor’s Depositary Receipt) became the model for the passive ETF explosion we see today.
The key word in that sentence is ‘passive.’
These days, most ETFs track an underlying index like the S&P 500 or Barclays Capital Aggregate Bond Index. Managers of the ETF will hold all the stocks in the index in proportion to the benchmark. Investors’ fortunes rise and fall along with the underlying index. There’s nothing wrong with this as evident by the nearly $385 billion in assets in the SPY alone. But sometimes investors are looking to do more and perhaps beat the underlying index or provide a different set of return expectations.
Enter Active ETFs
In an attempt to move past traditional indexing, many fund managers have turned to a more active approach with their ETFs. These funds function the same way as passive index ones do. That is, they are traded throughout the day on the major exchanges, use the same creation/redemption mechanism to buy and sell holdings, have authorized participants to create new shares, etc. The major difference comes down to management style.
As we said, passive ETFs will hold the stocks in proportion to their underlying index. There really isn’t much decision making by a human being. However, the opposite is true for active ETFs. Here, a person or investment committee will make decisions on the fund’s underlying holdings based on its mandate. How they make those decisions comes down to the two main styles of active ETFs.
Fully Active
A fund using a fully active approach allows managers quite a bit of wiggle room in accordance to their mandate. Here, a manager or group of people will make all the decisions on what stocks, bonds, and other assets—potentially including other ETFs—to include in the underlying fund. They may use a base index as a starting point for their deviation. For example, an active dividend ETF may use the NASDAQ U.S. Dividend Achievers Select Index. Managers have the ability to change allocations, conduct market-timing or sector rotation, focus on certain metrics they like, and deviate from an index as they see fit. Again, they can do this as long as they meet the investment objectives of the ETF. For the dividend ETF, a manager may overweight a few stocks in the index, eliminate others, etc. All of this is done to provide outperformance or a different set of return expectations.
Because of this freedom, active ETFs take many forms. Some like the BlackRock Ultra Short-Term Bond ETF (ICSH) try to improve on the returns of their benchmark. Others like the ARK Innovation ETF (ARKK) have no benchmark and are solely based on the underlying managers’ investment decisions.
Smart-Beta
The other form of active ETFs can be thought of as a blend between passive and active strategies. Dubbed ‘smart-beta,’ ‘strategic beta’ or even ‘factor-investing,’ they track an index with a twist. Managers will use various screens on a larger parent index to build their portfolios. They could look for various fundamentals like sales, earnings, book value, dividends or cash flows. They could seek to find more abstract concepts like momentum or size. More commonly, they could use a combination of various factors.
The key is that the managers of the smart-beta fund ultimately make the decision on what meets the initial screening methods and how each factor is weighted in the screen. That makes them active funds. For example, when looking at P/E ratios, you and I may have different views on what is considered expensive.
Smart-beta funds are like passive funds in that they track an underlying index. So, after the managers screen and create the framework for their fund, they create an index with these requirements. The smart-beta ETF will then track this underlying index, rebalance according to its mandate, etc. just like a traditional passive ETF. For example, rather than track the S&P 500, a smart-beta fund may track the S&P 500 Low Volatility High Dividend Index. The active decision was again in how the factors are screened and what combination works best according to the manager.
Check out this article to see how active ETFs can be an underdog with an advantage.
The Bottom Line
Both smart-beta and fully active ETFs allow humans to make the decisions with regards to fund management. For investors, the decision with the flavors of active ETFs comes down to how much control you want someone else having in your portfolio.
Smart-beta features a more ‘set it and forget it’ model, while fully active bets directly on the expertise of the fund manager. You can have both active ETF types in your portfolio. Knowing the difference and what that means is important to your decision-making process.
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