What is an Actively Managed ETF?

An actively managed exchange-traded fund (ETF) is an open-ended mutual fund that trades on a national stock exchange just as stocks do. Although most ETFs are passively managed index funds, in 2008 the U.S. Securities and Exchange Commission (SEC) approved the development of the first actively managed ETF, which does not track an index benchmark. An actively managed ETF is composed of a collection of stocks, bonds, and commodities and has a manager who does research and makes transactions.

Trading happens differently with an ETF than it does with mutual funds and stocks. Shares are purchased directly from the ETF in blocks called creation units that are composed of tens of thousands of shares. ETF shares are listed on national security exchanges and may then be traded on the secondary market by individual investors.

The SEC has specific transparency requirements for actively managed ETFs. Management must make portfolio holdings available daily with a one-day lag. This makes an actively managed ETF less transparent than its index ETF counterpart, but more transparent than a traditional mutual fund, which is only required to disclose once every three months. A potential problem with such frequent disclosure is that a keen observer may quickly determine an ETF fund’s management strategy and attempt to duplicate it without buying into the fund.

Actively managed ETFs have lower fees than mutual funds, even when managed by the same manager using a similar strategy. Yet because they are actively managed and experience higher turnover, they have higher fees than index ETFs, which require fewer decisions and trades. Actively managed ETFs also have a tax advantage over mutual funds. Capital gains taxes in the U.S. are less because of how the ETF is structured.

Even though ETFs that are actively managed have distinct disadvantages over index ETFs, they have one primary advantage. Index ETFs are tied to an index. The only goal of an index fund manager is to match the market. An actively managed ETF has more flexibility. Since it isn’t tied to an index benchmark, an actively managed ETF can beat the market with an effective manager.

Still, actively managed ETFs are much newer than other similar products and have yet to be embraced by investors. As of January 2010, actively managed ETFs made up only about $140 million US Dollars (USD), while the ETF industry as a whole is worth $1 trillion USD. Investors have stayed away from actively managed ETFs for several reasons. The degree of transparency makes it difficult for investors to hedge risk, and the product is still new enough that investors are not yet sure whether actively managed ETFs can beat mutual funds.