Relatedly, ETFs are highly transparent. They offer daily disclosure of holdings and position sizes and almost constant NAV updates. Buy-and-sell spreads in this space also tend to be relatively narrow — similar to that on large-cap shares.
Passive ETFs have their limitations as well. Perhaps the most obvious is that this form of investing amounts to “being the market” — that is, merely tracking and replicating the performance of a particular index.
Pure index funds can expose investors to only a small number of winners and a large number of losers. The extremely high levels of concentration in the S&P 500 in recent years illustrate this point.
The index delivered strong performance for much of 2023 and 2024, yet this was driven mainly by the “Magnificent Seven” mega-cap technology stocks. These now dominate global indices in a way that is arguably unhealthy.
At the other end of the table, fewer than a third of all S&P 500 constituents outperformed the index in 2023.
Most passive investors had no choice but to be saddled with this sizeable cast of underperforming stocks, notwithstanding the heroics of the minority of holdings.
Some ETFs invest thematically. They might focus, for example, on artificial intelligence or another source of sweeping technological advances. Again, though, there is no guarantee that every company in a given arena will be an enduring success, or even a success at all.
Active management can be a difference maker in this respect. It can enable selective investment in businesses with the strongest fundamentals and the brightest growth prospects, avoiding a broad-brush approach that encompasses too many unpromising stocks.
It can enable investors to beat the market — but in the current market, where the US and global indices have become arguably distorted, it can help mitigate risk.
Of course, active management must prove its worth and investors should choose managers with strong performance records.
Traditionally, though, active management for more generalist investing has only been available through mutual funds and investment trusts whose managers had the freedom to deviate from a benchmark.
However, in recent years, a fourth investment revolution has opened up new possibilities in this regard.
The rise of active ETFs
The first active ETF was launched in the US in the late 2000s. It pioneered the concept of an ETF that has a manager or team making discretionary decisions in relation to the fund’s underlying investments.
This approach seeks to unite the best of active management with the best of ETFs. The former includes greater flexibility in terms of portfolio management and potential for alpha generation. The latter includes enhanced liquidity, transparency and cost-effectiveness.
Active ETFs aim to deliver outperformance — often alongside unique, benchmark-agnostic exposure — at a lower price than a conventional actively managed fund. They may also entail tax advantages relative to open-ended mutual funds.
