ETFs: Actively evolving passive

Exchange-traded funds (ETFs) are structured to provide liquid, cost-effective and transparent access to global markets, with the ability to also offer intraday pricing to investors. The benefits of the ETF wrapper have contributed to the huge popularity of ETFs over the past two decades.

Until recently, ETFs have been synonymous with passive investment strategies. However, fund providers and investors are increasingly realising that the ETF wrapper is also an ideal home for actively managed investment solutions. 

The benefits of active ETFs

One of the key benefits of active ETFs is that they allow investors to target specific outcomes. For example, an active equity ETF can provide access to excess returns above a chosen index, driven by fundamental stock selection.

Because the weighting methodology in active strategies is at the discretion of the portfolio manager (within certain tracking error constraints), some active ETFs can partly mitigate some of the limitations of market-cap indices. Active fixed-income ETFs, for example, have the ability to assess the creditworthiness of individual issuers and deviate from the weighting methodology of traditional fixed-income benchmarks, which give larger weightings to issuers with higher outstanding debts.

Active strategies can be used to gain exposure to certain investment criteria, such as securities with strong environmental, social and governance characteristics. They also have the ability to rebalance portfolios outside of the systematic rebalancing dates used in passive indices – a key advantage that can help active ETFs react quickly to unexpected market events.

As demand for active strategies grows and more active ETFs are launched, it’s important for investors to have a full understanding of how they work compared to passive funds, and how they can be employed in portfolios.

Five things to consider when investing in active ETFs

As with passive ETFs, investors in active ETFs need to evaluate the capabilities of the ETF provider, the structure of the ETF and the cost of investing. However, with a growing number of active ETF strategies and investment processes to choose from, investors will also need to take a close look at the ETF investment engine. And with active ETFs raising additional questions about liquidity and pricing, investors should also look closely at the trading abilities of the ETF provider.

  1. Select an ETF provider that you value
    When evaluating potential active ETFs, investors should consider the character and capabilities of the ETF provider. Investors should choose to invest with a provider they value, and that has a proven history of delivering investment expertise and insights. 

    Investors particularly need to ensure the ETF provider is able to give them the level of client support they need. For example, does the provider have a multilanguage client service desk? Does the provider have a dedicated website that provides easy access to fund information? How well aware and aligned is the provider to the regulatory changes impacting the industry? 

  2. Evaluate the total cost of ownership 

    As with passive ETFs, the full cost of investing needs to be carefully evaluated. Low fees are attractive, but the total expense ratio (TER) is just one component of the overall investment cost of an ETF.

    As well as the TER, investors need to evaluate other costs incurred for holding an ETF, which include such factors as transaction costs related to portfolio rebalancing, and any costs and risks associated with the ETF structure. While the costs and risks associated with physical and synthetic (swap-based) index replication may be less relevant for active ETF investors, structural implications are still important to consider. For example, active ETFs may participate in security lending schemes to offset costs, similar to many physical replication passive ETFs. 

    Investors will also need to account for the cost of purchasing and exiting the fund. These charges include brokerage fees, and creation and redemption costs via the authorised participants (APs). Taken together, all of the costs involved in holding and all the costs involved in trading the ETF will provide investors with a view of the total cost of ownership (Chart 1).

Chart 1: Total investment cost
Chart 1: Total investment cost
Source: J.P. Morgan Asset Management. For illustrative purposes only.
  1. Understand the ETF investment engine 

    While active strategies strive to deliver potential excess returns over and above the benchmark return, the range of possible outcomes and performance deviations from traditional benchmarks will be much greater than with passive ETFs. Active ETFs will therefore require more upfront research and ongoing monitoring of performance and portfolio management than market-cap-weighted index strategies.

    In an active ETF, stock selection, investment allocations and risk management will be based on a portfolio manager’s investment philosophy, conviction and skill. It’s therefore vital that investors ensure the active strategy is based on a proven, repeatable process that aligns with their risk tolerance and overall investment objectives.

  2. Look at the liquidity of underlying securities

    Some active strategies and some asset classes will not be appropriate for the ETF wrapper, so it’s important to ensure that the ETF itself provides ample trading liquidity. First and foremost, a good active ETF strategy needs to maintain exposure to liquid and tradeable underlying securities, which will allow the cost of creating and redeeming shares to be low, and the ability to provide intraday pricing to be high.

    Investors should therefore look closely at the ETF’s starting universe of securities, which can be based either on a reference benchmark or the universe covered by the relevant portfolio management or analyst team. An active ETF with a starting universe of US equities, for example, will be more liquid and cheaper to trade than an ETF with a starting universe of emerging-market bonds.

    Investors will also need to look at the fund’s portfolio construction to get a full view of its liquidity profile. This means analysing the investment criteria used to select securities, the risk management tools that the strategy uses, any tracking error considerations that are in place, and any individual security restrictions or other portfolio constraints that will influence the make-up of the portfolio.

  3. Focus on trading expertise
    As with passive ETFs, a good active ETF should be backed by a dedicated capital markets team with a strong technology platform and strong relationships with a diversified set of APs. The ETF provider must be able to demonstrate that they can provide APs with all the information they need to deliver efficient pricing of the ETF, while utilising both primary and secondary markets to boost liquidity.

    For active ETFs, trading expertise is particularly important as active strategies have the flexibility to trade outside of their normal rebalancing period. This means portfolio managers can buy or sell securities to reflect a change in market view at any time. Investors in active ETFs should therefore ensure that the ETF provider has the requisite capital markets resources and technology support needed to deliver these extra trading requirements, while also providing best execution and price transparency to investors at all times (Chart 2).

    It’s also crucial to assess the ETF’s ability to access the secondary market – if an ETF suffers a redemption or receives inflows, it may not need to trade its underlying securities if an AP or market maker is able instead to find a willing buyer or seller for the ETF’s shares. However, the level of visible ‘on exchange’ liquidity may not provide the whole picture. Consolidated trading reports, which show the level of hidden over-the-counter (OTC) trading as well as exchange-based trading, can help give a better view of an ETF’s secondary markets access.
Chart 2: The ETF ecosystem
Chart 2: The ETF ecosystem
Source: J.P. Morgan Asset Management. For illustrative purposes only.
Using active ETFs in an investment portfolio

Active ETFs provide a powerful portfolio construction tool for investors. Today, advanced active strategies are allowing investors to build ETF portfolios with a level of sophistication and diversification that they couldn’t have envisaged even just five or ten years ago.

Active ETF strategies are well suited to helping investors build out the strategic core of their portfolios. At the same time, an active strategy can be used to add alpha to a portfolio with core passive holdings or to allocate tactically at different times through the market cycle.

For example, active fixed-income ETFs can use sector and security selection to maintain a very similar duration and credit exposure over time, making them ideal for investors looking to quickly and efficiently change their yield curve positioning or sensitivity to credit spreads. Other examples include adding alpha to a plain vanilla portfolio or using a growth-style ETF to reduce a portfolio’s value bias at relatively low cost

Active ETF case study: Ultrashort income

    The opportunity

    Rising US interest rates have implications for both short-term cash investors and longer-term fixed-income investors:

  • Cash investors have the opportunity to pick up yield further out along the curve for reserve balances, but do not want to significantly increase volatility

  • Fixed-income investors want to reduce the interest rate sensitivity of their portfolios while maintaining a steady, current income

  • The advantages of using an active ETF strategy (Chart 3)

  • Credit and duration exposure can be actively managed to target an ultrashort duration range (typically 0.25 to 1 year), a competitive yield and low credit risk

  • Fixed-income investors can use active ultrashort income ETFs to reduce credit and duration exposure in longer-term strategic portfolios while maintaining a steady and predictable income. The ETF wrapper allows allocations to be made quickly and efficiently as investment needs change and the macro environment evolves

  • Cash investors can use active ultrashort income ETFs to enhance the yields on their reserve cash allocations within segmented cash portfolios. The ETF wrapper offers low-cost daily liquidity, providing the defensive qualities needed for reserve cash allocations

Chart 3: Tactical solutions for reserve cash needs and strategic solutions for short-duration portfolios
Chart 3: Tactical solutions for reserve cash needs and strategic solutions for short-duration portfolios
Source: J.P. Morgan Asset Management. For illustrative purposes only.

Choosing the right strategy

  • Investors should ensure that the ETF provider has an investment process with a proven track record over a full market cycle, including through volatile markets

    • This will include looking at the strength and experience of the provider’s credit research capabilities and the expertise of the portfolio managers

  • Investors should also look at the targeted duration range for the fund and investigate the types of instruments the fund can invest in

    • For example, can the fund hold structured/securitised credit, which can provide attractive yields, particularly as rates rise but require greater resources to analyse credit quality

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