Young & Invested: Are active ETFs worth it?

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 26

Active ETFs cop a lot of heat from retail investors.

The wide uptake of passive ETFs has been built on the back of a growing aversion to active management. The specialised strategies that active ETFs offer typically demand a more expensive ongoing fee, setting a higher performance hurdle to passive peers from the get-go.

Investors have also become conscious of widely held research that attributes higher fund fees to long term underperformance. This has arguably disincentivised investors further, amid other pitfalls like higher turnover and unfavourable tax outcomes.

So maybe this aversion is justified. As someone who invests exclusively in passive ETFs – I’m inclined to agree with the crowd. Neither the high fees nor the evidence of perpetual underperformance impress me. But it doesn’t appear this sentiment is stopping ETF providers from launching waves of active ETFs.

Despite still being a small portion of the overall assets invested in ETFs globally, as of June this year, active ETFs now outnumber passive products in the US for the first time. And in Australia perhaps there is a similar story building. Andrew Campion, manager of investment products at the ASX, has made a bold prediction that active ETF listings will outpace index ETFs in Australia by FY26 – although passive products will continue to attract over 90% of CHESS inflows annually.

Source: BlackRock. July 2025.

Despite being battered with stories about unjustified fees, underperformance and tax inefficiency, why do the number of active funds continue to grow? It’s overly simplistic to attribute this entirely to performance chasing investors who seek to achieve alpha or outperformance over passive benchmarks.

But instead of reigniting the active vs passive debate, I’m going to take a spin on things and examine my own bias towards active ETFs, by looking at some of the ways they solve common investor problems. But first, let’s take a step back and look at the two investment styles and what they fundamentally aim to achieve.

Active vs passive

First, it’s important to note that all investing is active investing. Even a process as simple as picking an index-tracking ETF means you’re making an active decision. But in the context of this article, I’ll be using passive ETFs to refer to an instrument that aims to replicate an index, whilst an active ETF to describe a fund managed by a professional team, seeking to achieve a specific outcome.

So, what’s the fuss with active ETFs?

Morningstar conducts a semi-annual research report called the ‘Active Passive Barometer’ that measures the performance of active funds against passive peers in their respective Morningstar Categories. Every time the report is published the results show the same thing - over the long-term active fund managers struggle to outperform in most sectors and markets. In another study, we found that the main reason for this underperformance is active funds being handicapped by higher fees that create too much of a hurdle to overcome.

Source: Morningstar. Data as of June 30, 2024.

Then why would anyone invest in one?

It’s a fair question to ask and one that I have pondered myself. But investing isn’t purely a returns or alpha maximation process. Rather it’s a mechanism that brings us closer to achieving our goals, no matter how they’re shaped. As it turns out – active ETFs can help solve common investor problems that passive ETFs aren’t equipped to address.

Niche markets

In unique corners of the market, portfolio managers tend to exhibit an investing edge or competitive advantage over the benchmark. A good example of this are Aussie small cap equities. It’s not that small caps aren’t represented in broader indices, but this is one of the cases where active ETFs outshine passive options for investors who want the exposure.

The composition of the Aussie small cap universe is heavily skewed towards speculative mining plays of mixed quality. This proves particularly problematic with passive exposure. Since a lot of these companies are generally in their infancy, more illiquid and volatile, they are steeped with uncertainty surrounding future prospects. There is also a distinct lack of information available to investors. Whilst smaller companies disclose the same information legally required of larger traded companies, their presence typically commands less scrutiny from professional investors and the media.

In this scenario, active fund managers are at an advantage to exploit informational efficiency and filter for quality constituents. On the other hand, passive ETFs hold all constituents who pass a given size requirement, regardless of questionable quality or fundamentals. This results in diluted exposure and a higher concentration of lower-quality names.

We see evidence of small cap active outperformance in our Active/Passive Barometer study. The findings showed that active managers had an edge in Aussie small caps given the narrow market with limited information. And thus, active funds outperformed passive peers in the same category over long-term periods.

Source: Morningstar Direct. Data as of June 30, 2024. Returns have been annualised for periods exceeding one year.

Risk aversion

Volatility is a common concern for most investors.

It is a term quantified by standard deviation – often a proxy for investment risk. In simple terms, standard deviation calculates how widely a stock or portfolio return varied from the average return over a historical period. This measure helps us estimate the range of returns we can expect for a given investment. A high standard deviation implies that the predicted range of performance is wide and therefore the investment has greater volatility.

As we re-discovered in April this year, market volatility causes quite the stir among both institutional and retail investors. This is because we tend to equate such volatility with portfolio risk. Not that I’m blaming anyone for freaking out when the market suddenly dropped – April was equally unnerving for most of us. But I don’t think this is an all-encompassing fear younger investors need to have.

For those with longer investment horizons and no immediate need for withdrawal, volatility is largely a psychological game. The real risk is not earning high enough returns to meet your goals or suffering permanent capital loss. Short term volatility for higher long-term returns is a trade-off worth taking.

However, this isn’t the case for all investors. As we age and the need to access our funds draws closer, reducing allocation to assets with high volatility whilst maintaining similar exposure becomes relevant. Older investors or those with shorter goals face the consequence of selling when the market is down and therefore cannot afford larger market drawdowns.

For such investors there’s not much that passive ETFs can do to alleviate this fear – after all, you are accepting the volatility of the broad index. Interestingly, active ETFs are associated with higher standard deviation than passive peers, due to being at the whims of an investment team trying to achieve an objective. But it turns out this can be both a curse and a blessing. For investors looking to lower portfolio volatility, active ETFs offer unique optimisation techniques that passive peers lack to achieve this goal.

A good example of this mechanism is Vanguard’s Global Minimum Volatility Active ETF VMIN. The active strategy seeks to provide exposure to global equities however with an approach that provides lower volatility than the FTSE Global All Cap Index (AUD Hedged).

As promised in the investment objective, the fund delivered significantly lower volatility than its category average at both the 3 and 5 year assessable mark. However, the fund failed to beat the index with a lower Sharpe ratio* over the trailing five-year period, meaning it took lower risk but also delivered less reward.

This is likely because low-volatility strategies often sacrifice the upside to avoid downside. There are additional considerations when investing in funds that specifically seek to lower levels of portfolio volatility. However, this is a good example of how active management strategies can help investors achieve their goals in a more specific, calculated way that passive ETFs can’t offer.

Steep valuations

Between alarm bells from fundies, financial commentators and institutions, it’s no secret that the ASX looks stretched based on traditional relative value measures. Unsurprisingly, this is a reasonable concern for retail investors.

Market Strategist Lochlan Halloway recently explored a more sophisticated approach to price/earnings comparisons for the ASX 200. The figure below shows our aggregate price/fair value ratio for the stocks we cover against the trailing P/E of the ASX 200.

Source: Morningstar. July 2025.

Over time, these two measures have shown a strong correlation, though the relationship is not perfect. He concludes that currently the implied ‘fair’ price/earnings ratio is ~17x which sits below the market price/earnings of ~20x. But interestingly the ‘fair’ price/earnings for the market is higher than the 20-year average, meaning the historical average might be too harsh given the nature of the index today.

The purpose of this isn’t to ignite debate about whether the market is overvalued, but to illustrate why some investors believe this is a problem.

The most common form of passive investing is a market capitalisation weighted index fund. This approach assigns greater weight to larger companies and less to smaller ones.

For example, the largest company on the ASX, Commonwealth Bank, makes up around 12% of the ASX 200 and therefore passive ETFs will reflect these market capitalisation weights. The indirect active decision you are making by investing in a market cap weighted ETF is conviction in the winners staying the winners through the larger exposure.

As someone who invests in the Vanguard Australian Shares ETF VAS, I indirectly accept the concentration in the financials and materials sector as well as the currently elevated market valuation. However, this isn’t suited to every investor. Value investors who prioritise purchasing assets at a discount to their intrinsic value may not be suited to a passive ETF. In this case, an active ETF solution that either reduces the concentration of overvalued companies or excludes them entirely can be deployed.

An example of this is Dimensional’s Australian Value Active ETF DAVA. The fund employs a multifactor process anchored in the factor research conducted by Eugene Fama and Kenneth French. This looks at the lowest 45% of listed stocks on the ASX based on the price/book metric then applies value, size and profitability factors across the stock universe.

Concluding thoughts

Whilst I personally don’t own any active ETFs, I think it’s too simplistic to dismiss their utility despite the rise and popularity of low-cost passive products.

But it’s important to remember that fund managers are not stock-picking gods, nor do they have the same priorities as individual investors. Ultimately every investment decision we make is an active one and you might find that active products are indeed an appropriate strategy to get you closer to your goals.

It is important to note that any asset class should be considered as part of a well-defined investment strategy. For a step-by-step guide to defining your investing strategy, read this article by Mark LaMonica.

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*Sharpe ratio: The Sharpe ratio is one of the most widely used measures of risk-adjusted relative performance. It subtracts the safe market return from the expected return of an investment and ultimately divides that by the standard deviation.

If you have two hypothetical investments that both return 10% p.a. over the long term, the investment with the higher Sharpe ratio provides better risk-adjusted returns on the basis of lower standard deviation. In basic terms, you get a smoother ride to the same destination (although this rarely occurs in practice). You can read more about standard deviation and the Sharpe ratio here.