Actively managed ETFs are a relatively new category of exchange-traded product.
They offer the opportunity for market outperformance, but come with the potential trade-offs of higher costs, greater tracking error and risk of underperforming the market.
Like other exchange-traded products, active ETFs trade on an exchange and are open-ended. Ongoing costs are generally lower than traditional actively managed funds, but higher than traditional index funds and ETFs.
Commonly referred to as smart beta or strategic beta ETFs, these products seek to track alternatively weighted, rules-based indexes, with the goal of outperforming market-cap-weighted indexes. Factor tilts, for example toward value or small company shares, often explain the performance of these products relative to the broad market. (See the callout to learn more about factors.)
Alternatively weighted index products blur the line between active and passive management. They are index based, yet the construction of their benchmarks reflects an active decision to deviate from market-cap weightings.
The managers of these products seek to explicitly target a factor, or combination of factors, that they believe will deliver an investment premium such as outperformance or reduced volatility. (See the callout to learn more about factors.)
Active factor ETFs don't track a benchmark. Not being tied to an index rebalancing schedule gives the manager the flexibility to add or reduce positions as needed to maintain exposure to the desired factors. Active factor ETFs typically use a quantitative, rules-based security selection process to build their portfolios.
ETFs can differ greatly when it comes to the management of their underlying portfolios.
Index-based |
Market-cap-weighted |
Rules-based management |
Active management |
Active risk |
|
| Traditional index ETFs | x | x | |||
| Alternative index ETFs (e.g. "smart beta") | x | x | x | ||
| Active factor ETFs | x | x | x |
One way to think about factors is as the DNA of an investment. They are underlying attributes that explain and influence how an investment behaves. By targeting these attributes, factor-based investments attempt to deliver an investment premium, such as market outperformance or reduced volatility.
One factor you're probably familiar with is the market factor. Also known as equity risk, the market factor shapes and explains the risk and returns of a market-capitalization-weighted equity portfolio. Historically, a portfolio exposed to the market factor has outperformed “risk-free" investments such as short-term government bonds. This return premium has been an investor's reward for bearing the additional risks of equity investing. Other well-known equity factors include value, size and momentum.
Many investors' portfolios tilt toward certain factors and away from others, whether they know it or not. These tilts explain much of the risk and returns across a range of investments, including smart/strategic beta ETFs, active factor ETFs and traditional active funds.