What are active ETFs?

The Australian ETF market recently surpassed A$129 billion in funds under management, representing 35 per cent industry growth over the last year alone.

Unsurprisingly, as investor uptake grows, so does the variety of products on offer, with the ASX signalling that the majority of ETFs coming to market over the next 12 months will be active ETFs.

So what exactly is an active ETF and how are they different to index ETFs or actively managed funds? What are some factors to consider before investing in one?

A tradeable fund that is actively managed

Active ETFs function very similarly to an actively managed fund. Like an actively managed fund, active ETFs encompass a portfolio of securities selected by a professional fund manager with the objective of outperforming market benchmarks. This differentiates them from index-managed ETFs which seek to track the returns of a market index.

The difference between active ETFs and actively managed funds however is that active ETFs can be traded on a stock exchange and are required to disclose portfolio holdings on a periodic basis, potentially making them more transparent than actively managed funds which are not required to list out their selected securities (but sometimes do).

Thus, like an index-managed ETF, active ETFs are easily accessible, transparent and can be bought and sold during the trading day.

While active ETFs generally have a lower investment minimum than actively managed funds, they do carry higher costs than index ETFs to compensate for the time and resources required from fund managers to manage them.

Active ETFs may also have fewer securities in their portfolio, unlike index-managed ETFs which encompass sometimes hundreds of securities in the one fund and may thus provide more diversification benefits.

Different active ETFs will also have different investment strategies. Some are constructed to target a certain market or asset class (such as particular companies in emerging markets or equities with above-average growth potential), while others use rules-based active strategies to target the risk and return premiums of investment factors such as value and volatility. You can read more about factor-based investing here.

Things to consider when investing in an active ETF

Investors usually choose active management because they want to achieve returns greater than the broad market or reduce the impact of market volatility on their investments. Vanguard believes the three critical factors needed for success in active investing are: top talent, low cost and patience.

It's therefore important to do your own research and invest with a fund manager that you believe will have the investment team and skills to achieve your investment objectives. A few factors to consider are:

1. Fund manager – What is its history? Is it stable? Ask whether the ownership structure, ethics and incentives indicate a focus on its clients, and not on themselves.

2. People – What is the tenure and experience of the investment team including its analysts?

3. Philosophy – Is the firm able to clearly articulate how they view the market and find investment opportunities that others don't?

4. Process – How does the firm make buying and selling decisions? Does this make sense to you?

5. Portfolio – Does the portfolio reflect the characteristics of the manager's philosophy and process?

6. Performance – Take a look at the fund's long-term performance, and how and when the investment manager's firm, portfolio and performance is monitored.

Additionally, consider the fees associated with the active ETF. While they may be higher than index-managed ETFs, compare a few to see which is more cost efficient. The less you pay, the more of your returns you'll keep.

Remembers also to be patient. Active investing is focused on achieving long-term outperformance. So while your portfolio value may fluctuate in the short-term, investors fare best when they tune out the noise, trust their selected fund manager and remain disciplined over the long run.

Lastly, investors don't always have to choose between solely an index or active investment approach. Vanguard has long supported the core-satellite approach whereby index-managed funds form the stable "core" of a portfolio, and select active funds form the "satellites" and used as an opportunity to outperform the market or adopt style-driven strategies. You can read more about the core-satellite approach here.

Robin Bowerman, Smart Investing