Young & Invested: The hidden costs of active ETFs
Why investing in ETFs requires a deep dive into due diligence.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 40
“Learning to choose is hard. Learning to choose well is harder.” – Barry Schwartz
As the ETF landscape continues to expand, investors are faced with a challenge: how can we possibly make sense of the sheer volume of choice?
In a previous column, I explored whether active ETFs were ‘worth it’. The short answer: sometimes. Unfortunately, that’s not a particularly helpful conclusion. Active ETFs typically charge higher fees than passive ones with the promise of outperformance. Their ability to achieve this objective long-term has been mixed to say the least. But if you’ve decided they’re a product you want in your portfolio and have found a strategy and fund manager you believe will outperform, there is still a lengthy due diligence process to go through before adding it to your portfolio.
While there’s no foolproof way to separate the good from the not-as-good, I thought Morningstar’s Guide to Active ETF Due Diligence was a solid place to start.
Investing in actively managed ETFs involves more than just picking a manager and hoping they know what they’re doing. There are nearly 400 ETFs listed on the ASX. For the most part passive funds have dominated flows as investors continue to be rewarded by steadily rising markets and low costs.
The popularity of passive products is also fuelled by a growing scepticism toward active management, especially given the higher fees and perpetual underperformance.
Surprisingly this hasn’t deterred providers from launching new active products. In the year to 30 June 2025, 49 new ETFs hit the ASX. These were split almost evenly between 25 active and 24 passive funds. Clearly, the appetite for active strategies is alive and well.
The importance of bid-ask spreads
It’s easy to look at ETFs and assume the headline expense ratio tells you the full cost story. But for active ETFs in particular, there are other incremental costs that may quietly eat into your returns. One of the most overlooked are bid-ask spreads.
This refers to the difference between what you pay to buy an ETF (ask) and what you’d receive if you sold it (bid). Theoretically the fund’s true value sits somewhere in between this spread. Whilst a seemingly negligible cost, it can add up quickly, especially if you’re transacting frequently through short term trading or dollar-cost-averaging your paycheques.
Who sits in between these prices? We refer to them as market makers. Essentially, they are professionals who provide liquidity to the market and ensure there’s someone on the other side of your trade. The majority of their profits are derived from the bid-ask spread.
Certain strategies like multi-asset portfolios, niche thematic exposures or funds holding obscure and illiquid securities are harder for market makers to price and hedge risk accurately. This increases the risk they take on and lowers the likelihood of them turning a profit. To compensate for this, they demand a wider spread or may even temporarily withdraw from quoting. This absence can cause spreads to widen further until market makers re-engage to restore balance.
Bid-ask spreads are usually tighter when markets are calm and pricing is straight forward. On the other hand, during bouts of instability, market makers face higher risks and consequently spreads widen.
For example, in April when global markets suddenly fell following the tariff fiasco, spreads for even flagship passive funds widened. Popular pick for Australian equity exposure, VAS ETF with a typical spread of 0.02% jumped to 0.03% during the sell off.
What leads to narrower spreads?
ETFs that trade frequently are easier for market makers to manage.
High volumes generally signal investor interest and allow a rapid turnover of inventory with less risk. ETFs with larger AUM attract more attention from market makers and are more likely to be held in their inventories. This reduces the need for fresh creations or redemptions, but also fuels competition among market makers, lowering costs for investors and narrowing their profit margins due to tighter spreads.
One simple way to avoid falling victim to wider spreads is to use limit orders. Instead of buying at market price, a limit order lets you pre-define the maximum price you’re willing to pay or the minimum you’re willing to sell for. This protects you from sudden spread widening and ensures your trade only goes through at a rate you’re comfortable with.
Liquidity measures
Evaluating liquidity is a critical part of the active ETF due diligence process but also one of the most misunderstood. Unlike shares, we can’t accurately evaluate liquidity using the average daily trading volume or market capitalisation. This is because ETFs are open-ended and their supply expands or contracts daily through a creation and redemption process.
This flexibility lets ETFs scale with investor interest and absorb larger trades more efficiently than their historical trading volume might suggest. It’s for this reason that our diligence report advises that looking at average daily volume isn’t a reliable method to assess an ETF’s liquidity. Instead, we can use ‘implied liquidity’ which is an estimate of how much of the fund can be bought or sold without causing ripples in the underlying market. This is something a fund sponsor should be able to provide. In many cases, implied liquidity exceeds reported volume by a wide margin.
Liquidity also goes beyond ease of trading and bid-ask spreads. It can also be sign of structural resilience for investors concerned about investment viability. Funds that fail to attract sufficient assets over time will likely shut down. This poses a tangible risk to investors as it will likely trigger a tax burden or require them to search for a replacement product. The risk of this occurring in broad, low-cost passive ETFs is much lower given their ability to attract stable flows.
Fund failure isn’t just a phenomenon we read about. In 2022, investor interest in ETFs and the overall market was quite dull. It was also the year Vanguard’s Global Multi-Factor Active ETF VGMF was delisted at $42 million AUM, only three years after its inception. The reasons cited by the provider were “low asset growth since inception, client and market feedback, and modest anticipated future client demand”.
It’s important to note that there isn’t a direct link between levels of liquidity and a fund’s viability. But it can present as a symptom. If an ETF that has been on the market for a period and consistently trades at low volumes with wide big-ask spreads, it’s perhaps a signal of low investor interest and thus slow AUM growth.
AUM is the real risk factor for funds given issuers generally require a minimum level of assets to cover operating costs. When we think about the relationship between liquidity and asset growth, the old chicken-and-egg argument comes to mind.
Active ETFs with niche strategies and higher fees may struggle to gain traction among investors and build AUM. The odds of consistent outperformance become even lower as the approach narrows. But without sufficient scale market makers are less incentivised to support tighter spreads, leading to poor liquidity. That poor liquidity discourages new investors who are looking to keep costs down.
What works and what doesn’t
Our Guide to Active ETF Due Diligence found that the most successful active funds tend to focus on widely traded and highly liquid assets. These strategies allow authorised participants (specific firms that have agreements with fund distributors) to create and redeem ETF shares efficiently. This helps keep bid-ask spreads tight and trading costs low. More on this later.
Broadly diversified strategies also fair better. This is because they can accommodate fund growth by spreading assets over hundreds or thousands of securities, even in less liquid segments. For example, Dimensional Fund Advisors have active equity ETFs in the small cap and value category that hold hundreds of constituents. It theoretically allows them to gather billions in assets under management (AUM) without running into liquidity issues.
On the other hand, strategies that deal with illiquid assets like microcaps or exotics can struggle. Because ETFs can’t close to new investors like mutual funds can, demand spikes mean that managers may be forced to expand their holdings or take on larger positions than ideal in their focus market. This can dilute performance and lead to wider bid-ask spreads, especially if the underlying securities are hard to trade.
Our Active/Passive Barometer report measures the performance of active funds against passive peers in their respective categories, serving as a measuring stick to determine the odds of succeeding with an active approach. In some categories, such as Australian mid/small-blend equities, active managers have outperformed their passive peers more often than not.
But only looking at average return doesn’t tell the full story. Even in categories where active managers have an edge, low survivourship rates (percentage of funds that remain open over time) affect the chances of success. Active managers have their backs against the wall in most cases. High operational and regulatory costs, as well as rising investor expectations makes due diligence crucial.
There is a paradox worth noting here. Active managers tend to exhibit an investing edge in less efficient, unique corners of the market. Since these corners are often steeped with uncertainty, there is a distinct lack of information available to the broader retail market. This allows managers to exploit the informational inefficiency and mispricings to filter for better quality constituents.
But ironically, the areas of the market where active managers have the best chance to outperform are also areas where the ETF structure may struggle. These areas can involve illiquid securities which are harder to trade and more difficult to manage the liquidity needed for an ETF. So active ETFs may struggle to function well in the areas where active management has the best shot at outperforming.
That’s not to infer that active ETFs don’t work at all. But given the structural limitations, it’s worth considering whether the ETF wrapper is the best choice for certain strategies.
Concluding thoughts
Ever the sceptic, active ETFs certainly aren’t for me. But I can certainly understand the appeal. That being said, there is a considerable amount of due diligence required to evaluate an active fund for its long-term potential. This article attempts to scratch the surface.
Although I think the process shouldn’t focus on finding perfection. This is largely impossible in market that doesn’t remain still. As the ETF market continues to inevitably grow, it pays to hold each product to a high standard before adding it to your portfolio as well as consider whether the structural limitations of an ETF make sense for the strategy the manager is pursuing.
