Exchange-traded funds (ETFs) are securities made up of any number of other securities—stocks or bonds most commonly. Some ETFs track a specific underlying index like the S&P 500 or the Nasdaq, but these funds can be structured to fit almost any investment needs.
ETFs generally fall into two categories: actively managed and passively managed.
Passively managed funds follow the principle of a “buy and hold” investment strategy. Rather than trying to beat the market, these funds simply track and index or invest in particular assets regardless of short-term market fluctuations.
Actively managed ETFs, by contrast, employ a portfolio manager or team of portfolio managers who personally track the investments held by a fund and make decisions to buy, hold, or sell, the assets held within it.
The goal of these portfolio managers is to outperform the broader market indexes. They often measure their success by using a certain index as their benchmark.
If their portfolios provide a higher return than those indexes, then the managers can claim success. If they return less than their benchmark index, then they did not beat the market, and their investors would have been better off with some kind of passive investment strategy.
How Actively Managed ETFs Work
Many of the most well-known ETFs are passively managed, meaning they intend to perform similarly to a particular index, asset, or group of securities. However, there are now two specific types of actively managed ETFs as well: transparent and semi-transparent funds.
Until late 2019, only transparent actively managed ETFs were allowed. These funds were required to disclose their holdings on a daily basis. Investors would then know exactly what was happening to their money.
Semi-transparent funds, by contrast, don’t have the same disclosure requirements. They either reveal the contents of their portfolio less often or communicate their true holdings by using various accounting methods like proxy securities or weightings.
The main reason investment managers want the option for this kind of ETF structure involves concealing their methods from competitors. The small percentage of active managers who outperform the market don’t want others to know how they did it.
From an investor’s perspective, the only noticeable difference between these two kinds of active ETFs would be the frequency with which they receive information disclosing the fund’s holdings. Both kinds of funds, and also passive funds, trade on exchanges at prices that change constantly during trading days.
Pros and Cons of Actively Managed ETFs
As with any investment vehicle, these funds have their benefits and disadvantages. Both the pros and cons tend to stem from the fact that a person or group manages the fund’s assets on a constant basis.
The biggest advantage of an actively managed ETF is the potential for gains that could exceed those of the market at large. While very few investment management teams beat the market, those who do tend to produce outsized gains over a short period.
Greater Flexibility and Liquidity
Active ETFs could also provide greater flexibility amid market turbulence. When world events rattle financial markets, passive investors can’t do much other than go along for the ride.
A fund with active managers might be able to adjust to changing market conditions, however. Portfolio managers could be able to rebalance investments according to current trends, reducing losses, or even profiting from panics and selloffs.
Like passive ETFs, active funds also trade throughout the day (as opposed to some mutual funds who only have their price adjusted once daily), allowing investors the opportunity to do things like short shares of the fund or buy them on margin.
The premise of these funds relies entirely on the experience and capability of the fund’s management. Those who invest in actively managed ETFs don’t personally see these things happening. They will be reflected in the ETF’s share price and net asset value (NAV) , of course, and funds send out a prospectus periodically to update investors on new events and asset allocation changes.
High Expense Ratios
One of the biggest cons to holding shares of an actively managed ETF involves what’s known as the expense ratio.
All ETFs come with a cost—the costs associated with maintaining the investments of the fund. The portion of this cost that gets passed onto investors is calculated by dividing the sum of a fund’s costs by its total assets. This number, expressed as a percentage, is the fee that investors pay for the privilege of holding ETF shares.
Active funds tend to have higher expense ratios. The costs associated with paying a professional or entire team of professionals combined with the fees that result from additional buying/selling of investments adds up to a larger expense burden.
Each purchase or sale might come with a brokerage fee, especially if the securities are foreign-based. These costs exceed those of passive funds, resulting in higher expense ratios.
While active ETFs could provide higher returns, most of them don’t. It’s a widely known fact in the investment world that the vast majority of managed funds (as well as most individual investors) do not outperform the market over the long-term.
So, while an active ETF may have the potential for greater returns, the risk can also be significant. The chances of choosing an active fund that fails to outperform the market are greater than the odds of choosing one that succeeds.
The responsibility to manage the risks and rewards of an actively managed ETF lies in the hands of a fund’s managers, not the retail investor buying shares. This might not sit well with investors who want to have control over their investments and the ability to choose when to buy or sell. Holding shares of this type of fund requires putting faith into those who manage the investments.
One of the risks inherent in this kind of investing, although remote, might be that fund managers choose to misallocate investor’s funds or otherwise engage in deceitful practices.
It’s not unheard of for financial regulatory enforcement agencies like the Securities and Exchange Commission (SEC) to catch people in the act of overtrading (placing excessive amounts of buy/sell orders), making misleading marketing claims regarding a fund’s past performance, or gambling with the funds that investors have entrusted to them.
Deviation from Net Asset Value
Another reason why investors might not like a fund being managed by someone else is the fact that this arrangement can lead to the ETFs share trading at a price that is higher or lower than the fund’s net asset value (NAV). In other words, sometimes the tradable shares don’t accurately reflect the price of the assets the fund actually holds. This can happen with passive ETFs as well, but the deviation in active funds can be much higher due in part to the other factors discussed above.
In addition, even if the fund outperforms, that might not be reflected in the share price. The individual investment holdings of the fund might do well, but investors holding shares could see little to no profits due to the high expense ratios and potential deviation from NAV.
Investing in Actively Managed ETFs
It begins with choosing a fund that fits an investor’s wants and needs and then finding an exchange where that security can be traded. Once an investor opens an account at their chosen brokerage, they can begin buying shares or fractional shares of actively managed ETFs.
Historically, brokerages have required investors to buy a minimum of one share of any security, so the minimum investment will most often be the current price of one share of the ETF plus any commissions and fees (most brokerages eliminated fees for buying or selling shares of domestic stocks and ETFs in 2019).
Some newer brokerages now offer fractional shares, however, which allow for investors to purchase quantities of stock smaller than one share. This option may appeal to those looking to get started investing with a small amount of money.
It’s important to note that most ETFs pay dividends. Investors can choose to have their dividends deposited directly into their accounts as cash or automatically reinvested through a dividend reinvestment program (DRIP).
Investors with a long-term plan in mind might do well to take advantage of a DRIP, as it allows for gains to grow exponentially. For those only looking for income, DRIP might defeat the purpose of holding securities that yield dividends, however.
Learning About ETFs First-Hand
One way to get started with an actively managed ETF, should an investor decide to do so, would be to buy shares of a chosen fund. With SoFi Invest®, investors of all experience levels can gain experience by picking investments suited to their interests and financial ability. SoFi makes it easy for investors to diversify their portfolios and invest in what makes sense for their financial situation.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.
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