Understand the differences between active and passive Exchange Traded Funds.
Active Exchange Traded Funds (Active ETFs) are a simple way for investors to gain access to a wide range of asset classes.
They are open-ended funds, the units of which trade on an exchange, just like an ordinary listed security. They enable investors to gain access to a portfolio of shares [or other asset classes] in one easy transaction – either online or through a stockbroker.
Being open-ended means the responsible entity can issue or cancel units depending on investor activity. This dynamic means ETFs will generally trade very close to their Net Asset Value (NAV), which is very appealing to some investors. As a result, ETFs grow and contract in size based on both investment returns and investor activity.
Investors still need to be aware they are investing in a basket of underlying securities that can rise and fall in value, even with a portfolio manager selecting those shares in an Active ETF. So, understanding the market exposures and the timeframe for investing is important.
How Active ETFs differ from Passive ETFs
In Australia, the key difference between Passive and Active ETFs is whether they are designed to track a broad-based securities index such as the S&P500 index, or whether they comprise a portfolio of securities selected by a portfolio manager.
ETFs can also differ in the way the responsible entity provides on-market liquidity to investors, and in relation to the transparency of the underlying portfolio.
With an Active ETF, portfolio managers will undertake fundamental research to determine which underlying securities or stocks to hold and in what percentages. They will then actively manage these positions depending on valuations, industry trends and views on macroeconomics. They can also hold cash and use other techniques to manage the overall risk of the portfolio and take advantage of opportunities when markets move.
A Passive ETF tracks an index. This can be over a broad-based stockmarket index, a sector index, custom-built indices or indices comprising fixed income, credit, commodities and currency.
Passive ETFs can either fully replicate an index by buying all the securities that make up the index, or be optimised by buying the securities in an index that provides the most representative sample of the index based on correlations, exposure and risk.
Physical ETFs attempt to track their target indices by holding all, or a representative sample, of the underlying securities that make up the index. Synthetic ETFs rely on derivatives such as swaps to execute their investment strategy instead of physically holding each of the securities in an index.
Liquidity
In terms of liquidity, being open-ended unit trusts, units can be traded in the secondary market between investors, but they have additional liquidity provided by a market maker.
Passive ETF issuers largely outsource the provision of liquidity to third-party market makers such as investment banks. Market makers trade an inventory of units on an exchange and are able to apply or redeem with the ETF to settle their net trading position.
These market makers form their own view of the NAV of the ETF and provide bids and offers in the market around that value, within the bounds of their own balance-sheet risk appetite for providing this liquidity.
Active ETF issuers either follow the same market-making model as Passive ETFs or opt for the fund to provide liquidity by acting as a buyer and seller of the fund’s units around the issuer’s assessed value of the units at that time. The method adopted by an issuer will depend on whether the issuer wants to protect the fund’s portfolio information.
Transparency
In relation to transparency, investors have visibility as to the value of the underlying fund and the composition of its portfolio through regular disclosure provided on the exchange and the ETF issuer’s website.
The value of the ETF’s underlying investments is generally provided in the form of the NAV per unit and an indicative intraday NAV (iNAV) per unit, which generally updates throughout the trading day.
The level of portfolio disclosure will generally depend on whether the ETF is Passive or Active and, in the case of the latter, what has been agreed with the exchange.
Passive ETFs will provide an iNAV per unit and/or the full portfolio comprising names and weights of the investments, as well as monthly fund fact sheets.
Active ETFs will generally provide daily NAV and iNAV per unit, monthly fund fact sheets and a full portfolio comprising names and weights of the investments on either a monthly or quarterly basis.
Pros and cons
An Active ETF is a great way for investors to gain access to some of the world’s best markets and companies in one easy transaction on an Australian exchange. It avoids the complexity of investing directly via foreign exchanges and working through foreign tax regimes as they are investing in an Australian unit trust they can buy via an online share-trading platform or via a stockbroker.
With this ease of transaction, though, there is a cost paid by an investor in the form of commission or brokerage to that share-trading platform or stockbroker. Investors should weigh this cost against the time taken to deal with a managed fund using paper-based methods to determine the pathway best for them.
Magellan pioneers Active ETFs in Australia
In 2015, Magellan launched the first Active ETF in Australia, after working with regulators to balance the portfolio-disclosure requirements to ensure investors knew what they were investing in, but with the protection of the investment manager’s intellectual property (its portfolio holdings and Active portfolio decisions). This opened the door for more fund managers to bring their expertise to market via Active ETFs.
Magellan has taken this a step further with the next evolution of Active ETFs in early 2020 by enabling investors to access the same fund either “on market” via a stock exchange or “off market” via an application/redemption directly with the fund.
This gives investors access to the same fund through their preferred means and they can swap between the two worlds inside the same trust without triggering a capital gain or loss. This structure should now facilitate the transition of a range of unlisted funds onto the stock exchange.