How a new fund type works and why it will prove popular

The European exchange-traded fund (ETF) market has long been dominated by passive index-tracking strategies.

However, it is experiencing a new wave of growth and innovation with the emergence of actively managed ETFs.

While active ETFs currently account for a modest 1.9% of total ETF assets in Europe, this niche segment is poised for significant expansion.

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An ETF is a type of investment fund and exchange-traded product that tracks the performance of a specific index, commodity, bonds, or a mix of asset classes.

ETFs are traded on stock exchanges, allowing investors to buy and sell shares throughout the trading day at market prices. They offer a diversified investment option at a lower cost compared to many mutual funds, making them popular among both institutional and retail investors.

An active ETF, or actively managed exchange-traded fund, is a type of investment fund that combines characteristics of traditional ETFs and actively managed mutual funds. Unlike passive ETFs that aim to replicate the performance of a specific index, active ETFs employ a portfolio manager or management team to make investment decisions based on research, analysis, quantitative models and market forecasts.

Active ETFs offer investors the potential for higher returns through expert management while maintaining the liquidity, transparency and lower costs associated with ETFs.

The appeal of active ETFs lies in their potential to combine the best aspects of actively managed mutual funds, such as their objective to outperform benchmarks, with the liquidity, transparency and cost-efficiency of the ETF structure.

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This has caught the attention of several prominent asset managers, including Robeco, BlackRock's iShares, Eurizon Capital, and ARK Invest, who are either already offering or planning to introduce active ETFs in the European market.

Key trends and themes

One notable characteristic of the European active ETF landscape is the prevalence of “shy active” strategies, which exhibit lower active risk and conviction compared to traditional active mutual funds. This more diversified and benchmark-aware approach allows for greater scalability and lower fees, enhancing the competitiveness of these products against both passive and active alternatives.

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Sustainable investing has emerged as another key theme in the active ETF space. The flexibility of active strategies positions them to better adapt to the evolving ESG regulatory landscape compared to passive funds.

In terms of asset classes, fixed income initially dominated the active ETF market, particularly in the short-term bond segment. However, equity strategies have recently gained momentum, with significant inflows directed towards research-enhanced and quantitative equity funds offered by providers such as JPMorgan and Fidelity.

Multi-asset active ETFs, although still a small category, present an intriguing opportunity for disruption, with most strategies structured as “ETF-of-ETFs” offering investors a low-cost, diversified solution that could potentially challenge traditional actively managed multi-asset mutual funds.

Active ETF drawbacks

Despite the promising growth prospects, active ETFs face certain challenges. Capacity constraints pose a concern, as the ETF structure does not permit managers to close funds to new investors, potentially leading to strategy drift or dilution of returns if assets grow too large.

Furthermore, the higher transparency requirements associated with ETFs may deter some active managers who are hesitant to reveal their “secret sauce”.

Investors considering active ETFs should also be mindful of the potential for fund closures and mergers, a risk that is more prevalent among smaller, niche strategies. Focusing on established products from financially stable asset managers in core asset classes can help mitigate this risk.

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As the European ETF market continues to evolve, active ETFs are likely to play an increasingly important role in shaping its future. The combination of active management with the benefits of the ETF wrapper has the potential to disrupt traditional actively managed mutual funds and provide investors with a more diverse range of investment options. With the entry of more players and continued innovation, the growth trajectory of active ETFs in Europe appears promising.

The rise of active ETFs in Europe is part of a broader global trend, with similar growth observed in other major markets such as the US. That said, European-domiciled ETFs don’t have the same tax advantages as those domiciled in the US.

As more asset managers enter the space and investor demand continues to grow, active ETFs are likely to become an increasingly important part of the European investment landscape, providing investors with a compelling new way to access the benefits of active management in the convenient and cost-effective ETF wrapper.

Monika Calay is director, manager research, at Morningstar.