An Introduction to Active ETFs

In this article, we outline the history of ETFs and the recent rise in popularity of Active ETFs around the world.

THE HISTORY OF PASSIVE ETF INVESTING

ETFs emerged as a revolutionary financial instrument in the early 1990s, with the introduction of the first ETF in the United States, the Standard & Poor’s Depositary Receipts (SPDR), commonly known as the “Spider”, in 1993. This new innovation allowed investors to buy and sell shares of a fund that closely mimicked the performance of the S&P 500 Index, combining the benefits of diversification characteristic of mutual funds with the flexibility of daily exchange liquidity and trading. As mentioned in Broad-Based Benchmarks Seem To Be Short Disruptive Innovation, the sponsors of popular benchmarks like the S&P 500 Index and the Nasdaq 100 Index have shifted gradually from equity market benchmarking to passive ETF product licensing over the past 20 years.

As the passive ETF market has swelled in assets under management, it has led to an array of products offered across asset classes, including equities, bonds and international markets, as well as sector, smart beta and thematic funds. Many of these strategies were more traditionally captured in active mutual fund wrappers, and the creation of passive ETFs to capture these strategies led to a shift in vehicle adoption. As assets moved from active stock selection traditionally captured inside of mutual funds to equity market benchmarking captured in passive ETFs, what once was a reference measure of the health of the market became the market itself.

THE ADVENT OF ACTIVE ETFs

More recently, the advent of Active ETFs mark a significant development in the ETF landscape, expanding the realm of ETFs beyond their traditional passive roots. While ETFs have historically been synonymous with tracking benchmarks, the launch of the first actively managed ETFs in the late 2000s introduced a new dimension, combining the advantages of ETF transparency and daily exchange liquidity with the power of active management. Unlike their passive counterparts, Active ETFs were (and still are) managed by a team of experienced portfolio managers whose job it is to make discretionary investment decisions on stock selection, with the objective of outperforming a benchmark or the broader market.

The introduction of Active ETF products has allowed for greater flexibility in portfolio management and the potential for alpha generation in the ETF space, addressing the demands of investors seeking more tailored investment strategies. And, in the last decade, Active ETFs have experienced significant growth, with issuers expanding and diversifying their offerings into new asset classes, including fixed income and alternatives. Investor adoption of Active ETFs, meanwhile, has been fueled by their transparent nature, lower cost (especially when compared to traditionally actively managed mutual funds), and their tax efficiency in certain regions, helping cement their value proposition for modern-day investment portfolios.

ARK’S ROLE IN GROWING THE ACTIVE ETF MARKET

ARK Invest (“ARK”) has played a pivotal role in the popularisation of Active ETFs, especially in the realm of thematic investing in disruptive technologies. Founded in 2014, ARK distinguishes itself by focusing exclusively on, researching and investing in disruptive technologies that have the potential to change the course of history. These disruptive technologies represent the future of the global economy, embodied in powerful platforms like Artificial Intelligence (AI), Robotics, Energy Storage, Blockchain Technology and Multiomic Sequencing.

ARK’s approach to investing in these disruptive technologies is deeply rooted in active stock selection, with the business led by ARK’s Founder and CEO/CIO, Cathie Wood, focused on identifying and investing in companies that are the leaders, enablers and beneficiaries of disruptive innovation.

ARK’s entry into the market in 2014 has helped catalyse the accelerated adoption of Active ETFs around the world. It has helped ETFs compete on a level playing field with actively managed mutual funds, while also offering investors access to new types of investment opportunities in what’s a familiar wrapper. This has bolstered the Active ETF market size and inspired a whole new wave of entrants and products that seek to blend active management with the transparency, efficiency and accessibility of ETFs.

GLOBAL EXPANSION OF ACTIVE ETFs

Moreover, the growth of Active ETFs has not been confined to the United States. They have also seen adoption and expansion in international markets, including in Europe. Following their rise in the United States, European investors and asset managers have begun to embrace the active ETF structure since the late 2010s, recognising their advantages.

The regulatory landscape in Europe, including the implementation of the Markets in Financial Instruments Directive II (MiFID II), which aims to increase market transparency, provides a strong investment framework for the ETF market. MIFID II has spurred greater demand for transparent and cost-effective investment products, paving the way for ETFs to gain traction among both retail and institutional investors. As a result, the landscape of active ETFs in Europe is favourable, with European investors and asset managers alike leveraging the structure to build new and unique active strategies. This evolution underscores a global appeal for Active ETFs.

COMPARING ACTIVE ETFs TO ACTIVE MUTUAL FUNDS

As mentioned, the transparency, efficiency and accessibility (and typically, lower cost) of ETFs compared to traditional mutual funds have driven their popularity among individual and institutional investors alike, making them a staple for modern-day investment portfolios. To this point, Active ETFs may provide unique advantages relative to actively managed mutual funds:

Creation and Redemption Mechanism:

• • ETF’s unique creation and redemption mechanism involves large financial institutions known as Authorised Participants (APs) that can create new ETF shares by delivering the underlying assets to the ETF provider or redeem ETF shares in exchange for the underlying assets. This process helps keep the ETF’s market price close to its Net Asset Value (NAV) and ensures that liquidity is maintained, even for ETFs that might not have as much trading volume.
  • The ability of APs to directly create or redeem shares of the ETF in exchange for the underlying securities ensures that the ETF can accommodate large trades without significantly impacting the market price. This mechanism helps maintain liquidity and makes ETFs attractive for both retail and institutional investors.

Liquidity:

• • Investors themselves can buy or sell ETF shares at market prices at any time during trading hours, much like stocks. This ability to trade intraday enhances liquidity, allowing for quick entry and exit from positions.
  • Furthermore, ETF investors can use various types of orders, such as market orders, limit orders, and stop orders, to execute trades. This flexibility helps investors manage their investment more precisely and contributes to the liquidity of ETFs.

Cost Efficiency:

• • In addition to typical lower fees, the tax advantages and savings of ETFs can be very impactful relative to mutual funds. The in-kind exchanges noted above eliminate trading-related capital gains or losses. Non-transacting shareholders of mutual funds bear the trading costs and commissions that stem from net flows into and out of mutual funds, which is not the case for ETFs.
  • Cash drag can be detrimental to performance in mutual funds. On average, mutual funds hold large amounts of cash in order to meet anticipated redemptions. Due to in-kind creation and redemptions for ETFs, ETFs do not need to hold an outsized allocation to cash and can invest more directly into the intended portfolio strategy.

Transparency:

• • ETFs are highly transparent within the financial services industry. Regulators require daily disclosure of ETF holdings and position sizes, ETF NAV is updated every 15 seconds during market hours and ETF investors have almost instant access to portfolio holdings. For this reason, ETFs allow real-time analysis and management of risks, exposures and taxes.
  • In contrast, mutual fund shareholders lack control over real-time investment adjustments and must wait 30 days post-quarter for full holdings information. Timely information access in ETFs contrasts with the delayed info in mutual funds, leading to significant differences in asset management.