Investing basics: active ETFs explained

Active exchange-traded funds are growing in popularity.

More than 70 per cent of potential ETF investors say they would consider the active variant within the next 12 months, according to the latest BetaShares/Investment Trends report.

And this year alone, seven new active funds listed on the ASX. Alternative exchange Chi-X has also begun listing active-ETFs from managers Schroders, Kapstream and eInvest.

In this the last article in our Investing Basics series on ETFs, we'll delve into active ETFs - what they are, how they differ from traditional index-tracking ETFs, what advantages they offer for investors.

Active ETFs launched in 2019

Source: Morningstar Direct

More in this series:
Investing basics: what is an ETF?
Investing basics: the pros and cons of ETFs
Investing basics: how to find the best ETFs
Investing basics: how to buy an ETF via an online broker
Investing basics: what's so 'smart' about smart beta ETFs?
Investing basics: navigating the ETF universe

What are active ETFs?

In the words of Pinnacle's Chris Meyer, active ETFs (also known an exchange-traded managed funds) combine the benefits of active fund management with the convenience of being traded like a share on the exchange.

Unlike passive ETFs, which attempt to mimic the performance of an index, active ETFs are managed by a team of portfolio managers who make decisions on the underlying portfolio allocation and aim to outperform a benchmark.

If a fund is actively managed, it means a fund’s manager deliberately chooses specific investments for the fund’s portfolio that he or she believes will perform better or be less risky than other investments.

Related article: What is a managed fund?

Pros and cons

For a retail investor without a financial adviser or access to an investment platform, buying units in an unlisted managed fund has been difficult. Download a paper application form, print it, fill it in, sign it and send it via snail mail.

Unlisted managed funds for retail investors also often have minimum investment amounts of $5000 or more. This can be a minimum amount for the first time you invest in the fund, or every subsequent investment.

Because active ETFs are listed on the exchange, investors can buy and sell them as they would a normal share. Active ETFs also typically have non minimum investment amounts.

Australian fund managers see active ETFs as a new distribution channel to seek access to the self-directed market.

However, there are drawbacks. Unlike passive ETFs, active ETFs typically don't disclose their full portfolio holdings to the market on a daily basis, although there are some exceptions. This is because active managers want to avoid publicly sharing their investment strategies. Active ETF fees are also typically higher than passively managed ETF fees in order to pay the fund's managers and research team. 

Investors should also be aware of trade-offs between active ETFs and unlisted managed funds. Trading active ETF units incurs brokerage costs, and bid-ask spreads are variable. And for active ETFs that hold global stocks, given the underlying assets trade outside of the ASX’s open hours, there is also potential for spreads to widen during periods of volatility. 

Related article: 10 tips for effective ETF investing

Why go active?

Active managers will tell you that active investing can help investors minimise the effects of market downturns. Index tracking ETFs don't offer the potential for above-market value-add that comes with investing in an actively managed fund.

However, outperformance is not guaranteed. There’s no assurance that active managers will be able to pick investments that will outperform the benchmark or peer group. 

That said, there are many actively managed funds in which Morningstar analysts have conviction. Analayts assign Morningstar Medalist ratings to funds that they expect to outperform their category peers while accounting for risk over the course of a full market cycle.

Analysts rate and review active ETFs from providers including AMP Capital, Magellan, Platinum, Schroders, and Antipodes.

 Morningstar ETF screener

How are active ETFs priced?

The value of an active ETF represents the value of the securities it holds. Its value is determined intraday by dividing its total assets by the number of units on issue.

Active ETFs should trade close to the fund's underlying net asset value (NAV) of its holdings because when there is excess supply or demand, a market-maker steps in to create or redeem units.

Evolving industry

Magellan pioneered the new category of non-transparent active ETFs in 2015 with a listed version of the Magellan Global Equities fund. Since then, several funds have thrown their hats in the ring, and 19 active ETFs have launched since launched in fiscal-2017-18 and nine in fiscal 2018-19.

Today, there are over 30 active ETFs listed on the ASX from a range of managers including Fidelity, Platinum, Montgomery, Antipodes Partners, Legg Mason, K2, AMP Capital and Schroders.

Active ETFs still make up a small part of the $60 billion Australian ETF market, but funds are growing in popularity, with around $5 billion under management.

ETP Market Growth, June 2002 - 2019

Source: Morningstar

In July this year, the corporate watchdog ASIC announced it would block the listings of new active ETFs that rely on internal market makers while it conducts a review.

In a notice to the industry, ASIC asked all exchanges to "cease admitting non-transparent investment products [ETFs] with internal market markers for the time being" while it considers "the appropriate regulatory settings in this changed environment."

Related article: Regulator descends on rapidly expanding active ETF market

The regulator is concerned about the lack of transparency around the internal market making process and the potential of conflict of interest arising from the profits generated from it. It also said it was reviewing new regulatory frameworks for active ETFs in the US and Hong Kong.

Active ETF providers who do not use internal market makers but instead choose to disclose their full portfolios to external market makers are unaffected by ASIC's notice.

Learn more about Morningstar's Medalist active ETFs: