Vantage Point: Investing for growth  

What role can active ETFs play in portfolios?

  • Explain how active ETFs work
  • Understand how active ETFs differ from investment trusts
  • Identify the liquidity considerations associated with active ETFs
CPD
Approx.30min
What role can active ETFs play in portfolios?
Globally, there are thousands of ETFs invested in nearly $14tn worth of assets (Peter Nicholls/Reuters)

Active exchange-traded funds draw on features of actively managed mutual funds, investment trusts and ETFs.

Active ETFs differ from traditional investment structures. So what is causing a growing number of fund managers, advisers and clients to be attracted by them?

The first investment trust was launched in 1868 as a public limited company. By pooling multiple investors’ resources to purchase a diversified portfolio of securities, it democratised access to financial markets.

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Investment trusts — there are currently 349 of them managing £271bn of assets — are closed-ended vehicles. This means they have a fixed number of shares that trade on an exchange.

If a client wants to redeem their investment, they will have to sell their shares.

If many fellow investors feel the same way, these may trade at a discount to the net asset value of the underlying assets. If demand is high, clients may have to pay a premium to the NAV.

In recent months, we have seen many investment trust boards buy back shares to try to shrink the discount — with mixed results. 

The first open-ended mutual fund was launched more than a century ago. This allowed individual investors to buy and sell units of a fund at the same price as the NAV of the underlying assets at the end of each trading day.

As with investment trusts, investors were able to benefit from the professional management of funds. Should many investors want their cash back the manager would have to sell assets to meet demand.

In the event of this not being possible, the fund might be “gated”, with redemptions frozen until assets could be sold. We have seen this with property funds, for instance. 

These two active management approaches completely dominated investing until towards the end of the 20th century. The early 1990s saw the emergence of the first ETFs to earn mainstream attention. 

ETFs were a response to growing interest in the groundbreaking concept of passive investing. They introduced the idea of simply tracking a market index rather than relying on a fund manager to actively manage various holdings.

Particularly from the 2000s onwards, passive investing was widely embraced as a relatively low-cost, long-term strategy. Today, globally, there are thousands of ETFs invested in nearly $14tn (£10.8tn) worth of assets, according to research house ETFGI.

Being the market versus beating the market

Much of the appeal of ETFs lies in their ability to facilitate quick and easy access to multiple investments. This can make them a notably cost-effective means of enhancing diversification and reducing risk.

Importantly, the components of the index that a specific ETF tracks are treated as a single “basket”. They can also be traded whenever a stock exchange is open — as opposed to only at the end of each trading day, as with mutual funds.