There was a time when exchange-traded funds (ETFs) and passive investing were considered twins. Buy an ETF, and you’ll have a basket of securities that shadowed an index, most notably the S&P 500 or Nasdaq-100. There are no portfolio managers, no human judgement, and no potential for alpha.
That assumption now feels as outdated as the original food pyramid. Because over the past two decades, active ETFs have ballooned into a roughly $2.49 trillion corner of the ETF market, with that number growing faster and faster each year. Just this May alone, nearly $412 billion poured into the younger sibling of passive ETFs.1
As these ETFs mature, investors should take notice, starting with an understanding of how they work and what separates them from the pack.
An active ETF is an exchange-traded fund where a portfolio manager makes investment decisions about what securities the ETF will hold. Instead of mechanically mirroring an index, the manager behind the fund seeks to achieve something specific, like outperforming a designated benchmark, managing risk differently, or targeting a particular outcome.
The idea here is to balance the best of a mutual fund and the best of an ETF. Investors get the benefit of a manager’s experience with the same flexibility and cost-efficiency of an ETF. Shares trade on an exchange throughout the day. Pricing is transparent. The tax treatment generally tends to be efficient. The only difference is what’s held in the ETF. An active manager is driving the investment process instead of a rules-based formula tied to market-cap weights.
A passive ETF tracks an index, holds what an index holds, and gets as close to the performance of the index. If a few mega-cap companies dominate the benchmark, a few meg-cap companies will dominate the ETF, as well.
On the other side is an active ETF, where the manager can use their own judgement to select holdings. In practice, that can look like a manager overweighting certain stocks, avoiding other ones, and adjusting holdings as market conditions change.
Of course, like most things in investing, there’s a tradeoff. When investing in an active ETF, the investor pays for the manager’s presumed skill and conviction, betting that skill will add value over time. That’s why it can be a good idea not to pick sides. It’s not active vs passive. In some cases, it’s active AND passive.
Now we got that out of the way. Let’s get into the difference between active mutual funds and active ETFs.
| Active ETFs | Mutual Funds |
|---|---|
| Priced once per day, typically after the market closes | Trade continuously throughout the day, so you know what you’re paying |
| High expense ratios | Cost less than a typical mutual fund |
| Sometimes require minimum investments | With fractional shares, investors can buy as many or as few shares as possible |
| Discretion over buying and selling can lead to more trading and more capital gains | Fewer taxable events because of the creation and redemption process |
Summing it up, active ETFs employ a familiar approach while putting in a less expensive, more flexible, and tax-friendly package. This appealing combination explains a lot of the burgeoning demand.
Active ETFs aren’t one-size-fits-all. They come in a variety of shapes, sizes, and forms, including:
It’s no accident that active ETFs are becoming ever more popular. Several forces are sparking increased investor interest.
One major force was regulatory. In 2019, the SEC adopted the “ETF Rule" (Rule 6c-11), which streamlined how funds could come to market and made it considerably easier to launch active and semi-transparent strategies.2 The floodgates opened. The number of active ETFs has multiplied rapidly since, and asset managers who once sold only mutual funds have rushed to convert or launch ETF versions.
The benefits investors are responding to are significant:
Add it up, and it’s a market that reached roughly $2.49 trillion in assets. Only a decade ago such a figure would have seemed implausible.
A flashy wrapper doesn't guarantee good results. What is important is who is making the investment decisions and what the ETF holds.
The right question isn't "what index does this track?" but "what businesses does the ETF own, and why?" Strong long-term returns come from owning high quality companies, businesses with durable competitive advantages, sound financial health, and a runway for growth. When evaluating an active ETF, look past the marketing and ask these important questions:
Active ETFs aren't a magic solution to retiring at 32 on a beach with margarita in both hands. It’s like any other investment. It carries risk and can lose money. But for investors who want professional judgment in a transparent, general tax-efficient, tradable package, active ETFs can potentially be an option.