What are active ETFs and when will there be more for UK investors?

Here's everything you need to know about active ETFs, which are proving popular in the US.

When exchanged-traded funds (ETFs) were first created, they primarily tracked broad market indices such as the S&P 500. In this regard, for many investors, they were viewed as little different to index funds.

While ETFs have a different structure to index funds, meaning they can be traded during the day, many investors simply use them to gain cheap exposure to a market index. As a result, ETFs have become synonymous with passive investing. An investor with a portfolio of ETFs is assumed to favour the passive approach to investing over stock picking.

This was somewhat complicated with the introduction of smart beta ETFs. These ETFs track an index of stocks with some sort of pre-defined criteria, be it company fundamentals or industry exposure. As a result, their exposure is different to the main index and the hope of the investor is that this basket of stocks will outperform over the long term. However, while this starts to look a bit more like active investing, it still entails tracking a rules-based index and can therefore still be described as “passive.”

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However, increasingly, the ETF structure is being used for an actively managed portfolio – so-called Active ETFs. For some, an Active ETF sounds contradictory. However, it is 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 them 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.

The first active ETF was launched in 2008. However, many active managers have been reluctant to use the structure due to the requirement that ETFs report their portfolio holdings on a daily basis. This is not the case for other fund structures used by active managers. This raises the risk that fund managers building their position would be “front run” by other investors keeping an eye on their portfolios.

However, that all changed in 2019 following new rules from the US Securities and Exchange Commission. These new rules meant ETF fund managers could report their holdings less frequently, removing the front-running risk.  

As a result, active ETFs have soared in popularity in the US. According to FactSet, in 2020 more active ETFs launched in the US than passive ETFs tracking an index, for the first time ever. While some of these active ETFs still report their holdings daily, the vast majority don’t, giving rise to the new term Active Non-transparent ETF, or ANT ETFs.

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Many of these new active (or ANT) ETFs are based on new strategies. However, the rule change has also encouraged fund houses to launch ETF versions of their pre-existing active funds. For example, earlier this year, Fidelity launched an ETF version of its flagship Magellan fund, made famous by its success under Peter Lynch in the 1980s.

However, while active ETFs are taking off in the US market, do not expect to find many available to UK investors anytime soon. While a handful of active ETFs are available, such as Almalia Sanlam Active Shariah Glb Eq ETF (LSE:AMAL), there is less incentive to launch active ETFs here compared to the US market.

First, the rules governing ETFs in the UK and Europe have not been changed inline with the SEC’s 2019 change. ETFs under European regulation still must disclose their daily holdings – for now at least. So, while its possible we will see more active ETF launches, many active managers in the UK and Europe are likely to be reluctant while the current disclosure rules are still in place.

Second, one of the drivers of active managers using ETFs is the specifics of US tax rules. In the US, when an active fund in a traditional mutual fund's wrapper sells stocks, it can incur capital gains taxes for investors in the fund. ETFs, in contrast, are structured in such a way that they avoid this tax. This makes the ETF wrapper cheaper. As a result, following the change in regulations, ETFs have been an attractive structure for active strategies.

In contrast, a fund selling stocks within the portfolio does not incur a capital gains tax in Europe. Therefore, there is no inherent tax advantage for ETFs over traditional active fund structures in Europe. As a result, there is less incentive for active fund managers to switch over to the ETF wrapper.

That being said, there does seem to be demand for active ETFs in Europe. A recent survey from survey conducted by Brown Brothers Harriman of 100 professional investors in Europe found strong demand for more active ETFs.