Ask ii: what are active ETFs and why are they being launched?

A reader asks: “I’ve been reading about active exchange-traded funds (ETFs), but I'm not quite sure what they are or how they work, as I thought all ETFs were passive funds. Can you explain them to me, please?”

Sam Benstead, fixed income lead (pictured above), says: One emerging trend in the fund management industry is to launch “active” exchange-traded funds (ETFs).

We’ve seen big investment groups jump on the trend this year, including Columbia Threadneedle and Invesco. These groups will launch rival products to those already on the market from the likes of JP Morgan Asset Management and HANetf.

But what are active ETFs, and how do they differ from open-ended funds, regular ETFs and investment trusts?

Well, generally speaking, active ETFs allow fund managers to use an ETF structure (which allows investors to buy a fund as if they were buying a share, but without paying the 0.5% stamp duty charge) for a stock picking fund, where a professional investor builds a portfolio.

This structure solves some of the drawback of investment trusts and open-ended funds.

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Whereas investment trusts have a fixed pool of assets, and the price of the shares will diverge from the underlying net asset value (NAV) of the portfolio to create discounts and premiums, an active ETF uses specialist market makers known as “authorised participants” to keep the value of the listed ETF as close as possible to the underlying portfolio value.

Tom Bailey, head of research at HANetf, explained how this works in an On The Money podcast episode in April.

Bailey said: “The way that's done is essentially an ecosystem the ETF industry has, and the key part is authorised participants, who carry out what's called the creation redemption process.”

He explains that when there's lots of demand for an ETF, like with an investment trust, a premium can emerge, so the share price will be slightly ahead of the NAV. But rather than just letting it sit there, authorised participants, such as Jane Street or Flow Traders, see an opportunity.

These firms buy the underlying basket of stocks in proportion to what the ETF holds, then they'll come to the ETF issuer and hand over those stocks in exchange for ETF shares, which are then sold, which brings the premium down.

Conversely, if a lot of investors are selling the ETF, then a discount may begin to emerge. The authorised participants buy the shares in the ETF itself and exchange them with the ETF issuer for those underlying stocks.

“So, the authorised participants are making a small profit, arbitrage, and obviously they do this at a massive scale, but that's what keeps that price and NAV in line,” Bailey said.

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Using this ecosystem, an active ETF can offer instant dealing, but still trade at the true value of the underlying investments. In contrast, an investment trust will swing between premiums and discounts to NAV as demand fluctuates.

Instant dealing is also an advantage over open-ended funds, where dealing happens just once a day, and the price an investor gets for their fund units is uncertain until the trade is settled.

The difference between an active ETF and a more traditional ETF is that an active ETF holds a basket of shares or bonds that are selected by a fund manager, and may be regularly changed.

Most other ETFs simply track a stock market index such as the FTSE 100 or S&P 500, while some may track shares according to certain rules, like whether they are cheap, have above-market dividend yields, or invest in a certain theme, such as technology stocks.

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The boundaries are becoming more and more blurred between what constitutes an active or a passive ETF, but the new wave of launches are generally aimed at putting an actively managed open-ended fund into a structure that offers better liquidity.

For some, an active ETF sounds contradictory. However, it's important to remember that an ETF is just a wrapper, or structure. While historically this structure has been used to track an index of stocks, there is nothing inherent to the structure that stops it being used to track a basket of shares actively picked by a fund manager in the same way a manager of an open-ended fund or investment trust would.

Active ETFs on our platform include ARK Genomic Revolution ETF A USD Acc GBP (LSE:ARCG), Buffettique Growth ETP (LSE:BUFF), iShares US Equity High Income ETF USD Inc GBP (LSE:INCU) and Saturna Al-Kawthar Global Focused Equity ETF GBP (LSE:AMAP).

Advantages of active ETFs

• No stamp duty
• Instant dealing
• Very low likelihood of discounts or premiums
• Fees can be lower than other active funds
• Greater transparency as active ETFs often list all their holdings

Disadvantages of active ETFs

• Limited options on the market today
• Can be a spread between the buying and selling price of the ETF which adds costs
• Unproven in extreme market conditions
• Greater counterparty risk via authorised participants
• Difficult to control how large the ETFs grow