Are ETFs Active?

Some people think of ETFs as passive investments. However, that’s not really true.

ETFs and mutual funds are on a spectrum

ETFs and mutual funds are both regulated under the 1940 Investment Company Act. The main difference between the two is that ETFs can be traded on an exchange at live market prices, while mutual funds accept cash-flows daily and issue units to investors at the Net Asset Value (NAV) of the fund each night. Another big difference is that mutual funds are only required to disclose their holdings quarterly, with a six-week lag, while ETFs typically need to disclose all holdings daily so arbitrageurs can keep intraday prices in line with portfolio valuation.

However, it is NOT true to say that ETFs are index funds, while mutual funds are actively managed.

In fact, the first and largest sources of index funds are mutual funds.

Also, as ETFs have evolved, their portfolios have become more and more like “active” portfolios.

As Table 1 shows, traditional index ETFs have been complemented by more recent arrivals.

• First by smart beta funds, which created portfolio tracking factors very similar to those used to pick stocks for active mutual funds. 
• Then by active ETFs, provided they disclosed holdings every day. 
• And more recently by the SEC's approval of Precidian’s “non-transparent active” ETFs

Approval of non-transparent active ETFs has filled a gap in the spectrum between index ETFs and active mutual funds, allowing a more classic mutual fund structure (with hidden portfolio holdings) to trade like an ETF (intraday).

Table 1: Investment Company (1940 Act) funds include ETFs and cross the passive to active spectrum

Source: Nasdaq Economic Research

Actively weighted ETFs are increasingly popular

The attraction of actively weighted ETFs is nothing new. Data shows that “smart beta” ETFs have seen inflows of around $35 billion so far this year, with smart beta equity ETFs representing two-thirds of equity ETF inflows. 

Chart 1: Smart beta ETFs are seeing a high proportion of ETF inflows in 2019

Source: FactSet, Nasdaq Economic Research

Looking at smart beta ETFs over a longer timeframe, we see consistent inflows over almost a decade, adding to around $450 billion, and split across multiple factors (Chart 3).

To put that in context, total assets in ETFs just surpassed $4 trillion, but more than $1 trillion of that is in bond ETFs.

Regular readers might remember we also attributed the longer average hold times for ETFs to this trend, with investors who buy smart beta ETFs tending to hold them longer than traditional tactical ETFs.

Chart 2: Inflows into smart beta ETFs

Source: Sources: Nasdaq Economic Research, Credit Suisse

Passive ETFs offer tactical investors active exposure too

A recent academic study also pointed out that even market cap weighted indexes can offer active exposure to investors. The study found that very few ETFs offer portfolios even close to a “total market cap index.” In fact, they found that most mutual funds are better diversified than the majority of ETFs.

That’s partly because many ETFs are created as “building blocks” for investors. Designed to offer exposure to a specific thematic, sector, style or country. The result is that investors can construct ETF portfolios which also reflect active thematic exposures, even though the underlying portfolios might be passively managed with very low turnover.

Why is this important?

There are many myths about ETFs. One of the most dubious, given the data above, is that ETFs cause commonality of ownership which discourages price discovery, increases correlations, and some say even reduces governance on companies.

The reality is that ETFs offer incredible choice to investors. Not only do they provide cheaper access to underling liquidity in bonds, stocks and even commodities, but more and more they offer investors mutual fund-like exposures and returns too. That’s a good thing for investors.

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Phil Mackintosh

Nasdaq

Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency. 

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