Know your ETFs: why active?

Historically, most exchange-traded funds (ETFs) have been passive, designed to track or mimic a specific index – until now.

While passive management has dominated the market since the Global Financial Crisis, there is a growing demand for actively managed ETFs, which have been dubbed “the next frontier in investor innovation”. [1]

Because of their transparency, flexibility, and accessibility, investors now have more choices than ever.

The growth of active ETFs is driven by investors’ increasing appetite for this investment format and demand for a bigger variety of products. To meet this demand, fund managers are broadening their range of investment strategies offered as ETFs. Active ETFs’ asset under management (AUM) reached $1.17 trillion globally at the end of 2024, with $363 billion net inflows over that year [2]. Projections indicate that this will reach $4 trillion by 2030 [3]. This trend is also particularly relevant as investors seek actively managed options to help navigate today’s turbulent markets. 

Active ETFs defined

Active ETFs are not designed to replicate an index and typically aim to outperform a benchmark or sector. Helmed by professional fund managers, these ETFs use a proprietary mix of quantitative and qualitative investment strategies to inform buy and sell decisions. An active ETF usually aims to deliver alpha, a risk-adjusted return that beats a benchmark [4].

The rise of active

Active ETFs are increasingly popular among the next generation of retail and institutional investors, financial advisers, and other intermediaries.  

Their rise stems from a mixture of legislation, product development, and market events and trends that brought their unique advantages into focus. Here’s why:

Potential for outperformance

Active ETFs are managed by professional portfolio managers who leverage their expertise, research and insights to select securities they believe will outperform the market. This approach can potentially generate higher returns compared to passive ETFs, which track an index. It also gives investors access to institutional asset managers.

Adaptability to market conditions

Active managers can adjust their portfolios in response to changing market conditions, economic trends, and emerging opportunities. This flexibility allows them to capitalise on market inefficiencies and mitigate risks more effectively than passive strategies.

Diversification and risk management

Active ETFs offer more tailored diversification and risk management strategies. Managers can select a mix of assets aligned with specific investment goals, risk tolerances, and market outlooks, providing a customised investment experience.

Flexibility 

Active ETFs can be a valuable addition to a broader portfolio that includes index-based holdings, as they aim to deliver incremental returns or other client-specific outcomes. Their flexibility through low denomination trading and liquidity has the potential to enhance overall portfolio models, helping to improve client outcomes. 

Innovation and thematic investing

Active ETFs often focus on innovative and thematic investment strategies that align with long-term trends, ideas, beliefs, and objectives. These strategies may focus on themes such as disruption, mega-trends, sustainable investing, and unique insights and outcomes. By doing so, they can offer exposure to high-growth sectors and emerging trends that traditional index-based ETFs might overlook.

Active measures of risk

As with passive ETFs, investors can use beta [5] and standard deviation [6] to assess whether an active product meets its objective.  Additionally, there are two key risk metrics specifically applicable to active ETFs:

• Alpha

  A measure of how an ETF performs relative to a particular index or benchmark over a specified period, adjusted for volatility. It allows investors to determine whether a fund is outperforming or underperforming a passive benchmark. This metric is expressed as a percentage. For instance, an ETF with 3% alpha has exceeded its benchmark by 3%, accounting for the volatility of the fund’s portfolio. 

• Sharpe ratio

  The Sharpe ratio measures an ETF’s excess returns relative to its volatility. It indicates how much excess return is generated per unit of risk taken. The Sharpe ratio is expressed numerically, and anything above one is considered good. A higher number implies that an investor is compensated for taking on extra risk with relatively outsized returns. This metric helps determine whether an active ETF is taking substantial risk to achieve outperformance. Ideally, an ETF will deliver above-average returns while minimising volatility. 

Why choose either active or passive

Both styles of ETFs have their merits. Passive ETFs are ideal for investors seeking index-like returns with very low fees. Conversely, investors may gravitate towards active ETFs in order to seek to outperform the market, driven by the belief that professional managers can achieve superior returns.

1. "The Year of the Active ETF." Institutional Investor, March 2025. https://www.institutionalinvestor.com/article/2eesgfd1awgu19g2ypekg/innovation/the-year-of-the-active-etf.

2. Broadridge data, December 2024..

3. "Decoding active ETFs." BlackRock, December 2023  https://www.blackrock.com/ca/institutional/en/literature/market-commentary/decoding-active-etfs-ca-en.pdf.

4. Alpha is a measure of performance calculated by a comparison of the volatility of the portfolio versus its benchmark on a risk-adjusted basis. A positive alpha of 1.0 means the fund outperformed its benchmark index by 1%, while a negative alpha indicates underperformance.

5. Beta measures the sensitivity of a fund in regards to the movement of its benchmark. A beta over 1.0 means that the investment has been more volatile than the benchmark, while a beta of less than 1.0 represents less volatility. 

6. A standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue-chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.