What are active ETFs and should you invest in them?

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In this week's On The Money podcast, interactive investor’s Sam Benstead discusses how active exchange-traded funds (ETFs) work with HANetf head of research Tom Bailey. They cover how active ETFs accurately track their underlying positions, why this type of investment product is becoming more popular, and the advantages and disadvantages of active ETFs compared with investment trusts and open-ended funds.

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Sam Benstead, fixed income lead at interactive investor: Hello. I'm Sam Benstead. Kyle is out of office, so I'm stepping in for another week to host On The Money, the weekly look at how to get the best out of your savings and investments. This week, we are discussing active ETFs, a relatively new type of exchange-traded fund that allows instant access to actively managed portfolios. With me to discuss this product is Tom Bailey, head of research at ETF firm HANetf.

Tom, thank you so much for coming on the podcast. We're here to talk about ETFs. These are now quite a normal investment vehicle, but they haven't always been. Can you please talk me through the history of ETFs and how we got to where we are today?

Tom Bailey, head of research at HANetf: Thanks Sam. Thanks for having me. Pleased to be here. Yes, we can go right back to the start. I think it's illustrative of the changes we've seen in ETFs. So, the origins of ETFs actually lie in the 1987 market crash, Black Wednesday. The report the SEC published after that crash essentially said that it would've been great if there was a tool for investors to buy the entire market intraday, which could have stemmed that big drawdown. Now, a guy called Nathan Moss noticed that in the report. Several people did, but Nathan Moss did, and it inspired him to think about how he could create that tool.

Because, obviously, back then there wasn't an ETF. There wasn't a way you could buy the entire market intraday in the middle of trading hours, right? You could do an index fund, but, obviously, that only deals at the end of the day. So, with that in mind of how to create that, he set about trying to create it. And the combination of that is basically in 1993, the creation of SPYDER (SPY), the biggest ETF in the world most of the time, sometimes the Vanguard S&P 500 tracker takes over, but this is the biggest ETF in the world, the oldest ETF in the world. So, that's the first ETF.

The launch of that ETF, obviously it was built to track the entire market and be a tool to buy the entire market, the S&P 500 in particular. At the same time as you saw investors increasingly aware of that tool, start to use it, and be aware of ETFs themselves, was around the same time that you also saw this growth of passive investment.

Passive and ETFs are not the same thing, but the two kind of grew up together and and came to prominence together. So, I think that what that created in the mind of many investors was this kind of synonym between passive ETF, which you still see today. But, within 10 years of the launch of that, you saw the first gold ETF, or ETC technically, launched. Our co-CEO, Nik Bienkowski, essentially invented the first gold exchange-traded commodity back in the early 2000s. So, there was this expansion of what you can actually do inside an ETF.

It doesn't just have to be the S&P 500, instead that's tracking the price of gold. And then in the 2000s, in 2008, you saw the first active ETF launch in the US. And then you saw the new products emerge, kind of utilising research from French and Fama around different factors and doing smart beta ETFs with a tilt towards value or growth or quality, etc. And then they took on an interest in 2010s. At the same time, you saw this approach towards thematics in terms of screening stocks for revenue exposure to certain areas to try and capture these broad themes.

And so you saw that expansion of the use of ETFs. And so as I mentioned, the active ETF has been around since 2008. That's when the first active ETF launched in the US, but it's really been for the last six years, I'd say, that we've seen a strong, real kind of substantial growth in active ETFs in particular in the US. It's coming to Europe, but in Europe, I think we're usually always around, like, five to 10 years behind the US on these trends. But last year in the US, 80% of new ETFs that launched were active.

Essentially, no one is launching the mutual fund anymore in the US. The default wrapper has increasingly become the ETF itself, and then we start to see that trend come towards Europe. Last year in Europe, active ETF assets under management (AUM) in aggregate grew by 68%. We're seeing strong movement there, but at the same time, it's still relatively early days for Europe. So, something like 2.6% of all ETF AUM in Europe is an active ETF. So, early days, but the active ETF is increasing the game in dominance.

Sam Benstead: And before we go a bit deeper on active ETFs, can you just explain to me how ETFs work? How through one transaction you can accurately own an underlying basket of shares and you're paying the right price for them?

Tom Bailey: Yes. So, it's a good way to explain active ETFs, right? Because you explain the mechanism and then where active is slightly different. So, if you take a conventional ETF, obviously, you have an index, say, the FTSE 100, and then, obviously, the ETF structure, the fund wrapper will buy those stocks in proportion. You have a portfolio manager to do that. Then the ETF issuer will have shares issued against the ETF, which investors can buy. So, those shares and ETFs trade on exchanges throughout the day, so it's on the stock exchange or the New York Stock Exchange.

Any investor can buy them through a platform like ii throughout the day. Now, that sounds like an investment trust, right? Because that's also what an investment trust can do. But the key difference with an ETF is the creation redemption process, and this is what keeps the price and the net asset value (NAV) of the ETF in line.

So, essentially, the price of the shares in the ETF in proportion to the value of the underlying stocks. Listeners familiar with, say, an investment trust, [know that] it trades sometimes at a premium or discount. So, that's the issue the ETF had to overcome to come into existence, and how you can have that intraday trading throughout on the exchange without having big premiums or discounts emerge. The way that's done is essentially an ecosystem the ETF industry has, and the key part is authorised participants. So, they carry out what's called the creation redemption process.

So, we take that basket of stocks, say there's strong buying for it, a lot of investors want it, then you'll start to see, like with an investment trust, a premium emerge, right? So, the share price will be slightly ahead of the NAV. Now, rather than just letting that sit there, as soon as that starts to emerge in a notable way, these authorised participants, people like Jane Street, Flow Traders, some of your listeners might have heard of [them], will see an opportunity there. They'll come in and see that premium. They'll buy the underlying basket of stocks in proportion to what the ETF holds, then they'll come to the ETF issuer and hand over those stocks to us. In exchange we'll give them shares, and then they can then sell those shares on to the market, and that will bring down the premium.

Conversely, if a lot of investors are selling the ETF, they don't want the ETF anymore, or at least a notable number don't want the ETF anymore, then you might see it start to trade at discount. So, the price of the shares of the ETF at a discount to the NAV of the underlying stocks. That will then see the authorised participants come in as well, as they see an opportunity.

They'll buy the shares in the ETF itself and exchange them with the ETF issuer for those underlying stocks. So, the authorised participants are making a small profit, arbitrage, and obviously they do this at a massive scale, but that's what keeps that price and NAV in line.

Now, when it comes to an active ETF, the only difference really is that first step, the security selection. So, if you go back to what I originally said in terms of we take the FTSE 100, the portfolio manager is buying the stocks in proportion to the FTSE 100. Instead of doing that, the portfolio manager is like your typical portfolio manager for an investment trust or a mutual fund or an OEIC, who is basically buying those stocks and weighting those stocks to what he believes has potential to provide outperformance to whatever his benchmark is.

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Sam Benstead: The first I heard of active ETFs was in early 2020 when Cathie Wood's ARK Innovation ETF A USD Acc GBP (LSE:ARCK) was all in the media. Everybody followed what she was investing in, and this was an ETF product that actually tracked the positions of an active fund manager. It was often compared to Scottish Mortgage in the UK in terms of what it invested in. But what do active ETFs look like now in the UK? What’s on the market and how are we defining an active ETF?

Tom Bailey: If you look at data providers, you see a discrepancy sometimes in the numbers because of different definitions, but at HANetf we don't have a strict definition, so to speak. Historically, you've seen these benchmark-aware products where, and I think this is kind of indicative of the early days of active ETFs, there's some attempt to outperform the benchmark, but hugging very close to the benchmark. Not the kind of, you know, when people talk about closet trackers, it's very transparent. This is what they're doing, they're trying to add a bit of outperformance. I think that reflected the early days of the active ETF market, and there's been some demand for that. But now what you're getting is quite a change in approach. So, what we're seeing is more high-conviction active strategies come to market.

You mentioned Cathie Wood in the US, obviously that’s a very high conviction fund, for better or worst. But if we look at who's entered the market recently, we launched an ETF with Guinness, by no means a shy active [manager, but a] fund house of high conviction. We launched an ETF with them last year, as well as Jupiter. What we're seeing is a lot of the traditional fund managers realising that the ETF space is something to look at now and adding ETFs to their distribution tools.

Sam Benstead: If you have the option of an ETF of an active product or an open-ended fund of the same active product, same management team, what would be the advantages and disadvantages of choosing the ETF over the open-ended fund?

Tom Bailey: It's a very strange mutual fund structure. I think it's quite archaic in many ways. What else do you buy where you don't actually know the price you're going to end up transacting at?

It's hard to think of anything else in the world you do that in, at least on a consumer basis, right? But that is the case with mutual fund. If you buy at 12:00, you're getting the price at the close of market. So, you don't actually know what price you're buying at.

Now, not all investors necessarily care about this, but it's a strange archaic structure in that way, and a clear advantage is that you know the price you're buying at. There might only be small discrepancies, but in periods of volatility, it might make a difference, right? So that's one.

Another one is the cost structure, not the fee, because the fees can vary, but more the cost structure. So, you can point to this as an upside or a downside to ETFs, or one in the ledger for ETFs, one in the ledger for mutual funds.

But if you take a mutual fund, when someone buys into that mutual fund, the cost of the portfolio manager buying the stocks in proportion to what he wants for his allocation is borne by all the investors in it. Now, if you're an existing investor, that's detracting from your performance, right? Because you're paying for that transaction cost inside the wrapper. With an ETF, that's not the case. That transaction takes place outside. It's the authorised participants who come along, provide the shares for the ETF. So, you're not getting that shared cost of maintaining the portfolio in that same way.

But what it does mean, because it transacts on an exchange, there is a spread to buy the ETF. So, if you look on ii, you'll see the bid/ask spread on your screen. So, you are paying that spread potentially. Now, all ETF companies work to minimize that spread, but sometimes it's a function of the liquidity of those underlying stocks.

So, it is a cost that investors pay, but our view would be that it's a fairer cost structure. If you want to buy into the ETF, you want to sell the ETF, then you obviously eat the spread. That's a cost that you bear. The other investors inside the ETF are not affected by your decision-making, whereas with a mutual fund, they are affected by the decision-making of investors. You can look at it either way, but we think it's a fairer cost structure.

Sam Benstead:You mentioned you partnered with Jupiter. That was on a fixed-income ETF, wasn't it? How does that work when buying bonds? Is that a different process to equities?

Tom Bailey:Not really. It's still the portfolio manager, and the way [it] would [work with] the mutual funds buying those bonds. It doesn't really function any differently than you expect other than in terms of the difference of buying a bond versus buying equities.

Sam Benstead:And what happens when an active ETF becomes too small or too large? When looking at open-ended funds, they often put limits on the size of portfolios, which is the fund manager saying, actually, we can effectively manage this strategy up to a certain point where we might become too large to buy what we really want to buy. So, what happens with ETFs if they become too large or too small?

Tom Bailey: If an ETF is too small, like with all funds, if the economics aren't there for an asset manager to continue to run it, then, obviously, they'll look at potentially closing that fund. That's the same for all funds. Asset managers are not there to just provide funds for no reason. There has to be an economic rationale for their business.

In terms of the size, that's a nice problem to have. Active ETFs are at 2% of ETF AUM in Europe right now. It's not necessarily a problem yet, but it's obviously something to keep in mind. If what we think is the case, that ETFs will become the default wrapper, then it's going to be something that will be confronted at some point.

So, with a mutual fund or an OEIC, etc, you can gate the product to new money and that's how you deal with that size. With ETFs right now, obviously, one aspect is that the fund itself would have to be very big, and also big in proportion to, say, the liquidity or size of the underlying stocks. That's why you do it.

Most active ETFs you're seeing now are still relatively small and also still investing in relatively liquid strategies. With a mutual fund or an OEIC, the asset manager themselves closes new flows because they take the flows themselves. You subscribe to the asset manager themselves. Obviously, as described, you have this whole authorised participant creation redemption process.

So, instead, you would essentially tell the authorised participants in so many words to stop doing new creates on the product. The result of that would be the ETF starts to trade at a premium. So, in some ways, it will start to look like an investment trust in that regard, but that would stop new money coming in.

But what it wouldn't do in terms of mutual fund if you stop new money coming in, is obviously no one can buy it anymore. In ETFs, keep in mind, there's a primary market, which is that whole authorised participants process, and then there's a secondary market, and there’s are just shares traded on an exchange.

So, you would essentially close the creation in the primary market, and then it would go to a premium. It’s not ideal for an ETF because that's obviously what we want an ETF to do is to trade in line with its net asset value and not be at a premium or a discount, but that's what you would essentially do.

And then investors can then buy and sell those shares on the exchange. So, investors can sell at a premium into the market if there's a counterparty who wants to buy that fund at a premium still, if that's so as they wish. It essentially would look like an investment trust.

So, it's not an insurmountable issue. It's something that would, in theory, work very seamlessly. Whether we'll see other approaches to that as it starts to become an issue [remains to be seen]. I think the ETF industry is very creative and [has] the ability to consider how to make this work the best and try to keep what everyone wants to do, keep the price and NAV in line. But if you did need to gate it, at least gate inflows or outflows, you could do so.

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Sam Benstead: Have there been examples in the past where you see problems with the valuation of ETFs? Perhaps during a market crisis where lots of people want to take money out, or a hugely successful launch where lots of money is flowing in. Have there been issues finding a real market price for the underlying assets?

Tom Bailey: Not in terms of at a launch with new money coming in. There's some interesting examples of ETFs surviving through market volatility. A good example would be when the Greek stock market closed. Obviously, there were ETFs tracking a basket of Greek stocks. What a lot of the authorised participants and the market makers in the ETF ecosystem do is they always try to determine the price also through correlation of other assets.

So, obviously, with the exchange closed, those stocks couldn't trade, but the ETF is listed on the London Stock Exchange, it's still trading, but you don't know what the value of what's underlying is. But using correlations of other asset classes, they could work it out roughly, and when the exchange in Athens reopened, then you did see the price attract relatively well.

Another example though would be, say, during Covid, when you saw real volatility in the US bond market, you saw some of the fixed-income products in the US, ETFs, get dislocated on price and NAV. No one wants price and NAV to diverge, that's the whole point of the ETF.

But with the kind of illiquidity in the bond market, lots of people wanted to redeem out of their bond funds, be it ETFs or mutual funds. Now, if you took the ETF version, what essentially meant was that it ended up trading on a big discount because the price couldn't come back down in line of the underlying because no one knew what the price was. So, trading at a discount. But we say that comes back to the fairer cost structure.

So, if you take a similar scenario with a mutual fund, essentially, you're getting people coming to redeem out of mutual funds. The fund manager is going to sell the parts of the market which are not gummed up, which are liquid, leaving those inside it stuck with basically the rest of the market, which they can't sell. That creates a bit of a bank-run dynamic, right?

Because even if you weren't planning to sell, you didn't need that liquidity to [sell out of] your bond fund, you're then incentivized to do so, so you're not the last one holding basically the basket of bonds, which you're not able to sell.

Whereas with the ETF, what it meant was if you really needed to sell now, you could. You would just take that hit yourself in terms of the difference between price and asset value. So, I think ETFs are quite a resilient tool in that regards in terms of what they offer. That's the two layers of the primary market and the secondary market.

Sam Benstead: Let's talk about the range of active ETFs that you can buy. We've spoken about pure actively managed funds where a stock picker picks their basket, which they think is going to outperform. But there's other active ETFs out there, aren't there. Thematic ETFs might be categorized in this bucket. Can you just explain what those are?

Tom Bailey: If you take, say, thematic ETFs, because of this historic focus on using index-based products for ETFs, index strategies for ETFs, a lot of the thematics in the ETF fold are index-based. So, they'll construct rules around revenue exposure or scanning for IP disclosures to try and fit stocks in that match the theme to provide disclosure to. But there's no reason why an active manager can't do that as well, right?

Because if you look at, say, the mutual fund world, there's a lot of actively managed thematic products out there. So, are thematics active or passive? Obviously, how they're used, it's an active bet. You think, say, the defense sector is positive. You want to avoid that in your portfolio. That's the investor being active, but if it tracks an index, that's less active in that sense. But at the same time, there's rules written. You make a choice that to be included in this ETF, a stock must have 50% exposure plus revenue to defence. That's obviously moving away from a market-neutral position, so there's less active.

But what we're seeing too is the actual active in terms of a portfolio manager who says, for example, [our] productportfolio manager says, ‘I know the ins and outs of sustainable energy stocks’, and providing that exposure through the active management skill. So, I think there's a place for both, and essentially, what you're seeing is some of the strategies which would have been in an investment trust, an OEIC, etc, are just being put into an ETF as well.

Sam Benstead: And the other area, which I think is quite interesting, is what you might describe as smart beta, where there are set rules, not on the themes that company is in, but on characteristics around the companies, be those value measures or growth measures or dividend measures. So, you actually build a portfolio which allows you to do something a bit different than the underlying index. Would those be considered active ETFs too?

Tom Bailey: I personally wouldn't consider them active because as I described, constructing those rules, there's an element of activeness in terms of moving away from a neutral benchmark market. And also how it's implemented as an active choice of the investor, so do they want 2% in this product, 5% in this, is obviously active management within a portfolio.

I wouldn't necessarily describe those products as active because I think that muddies the waters a bit for what we are seeing, which is the actual active products. With the smart-beta question, they were quite popular around 10,15 years ago, and dividend products are still very popular.

But one of the issues is that while you have all the historic data on value stocks outperforming other stocks, it's not actually been the case. And there's only so long that an ETF which doesn't provide performance will continue to attract assets into it. So, what's the appeal of a smart-beta growth product when, obviously, if you look at the market over the last 10 years, it's been very heavily skewed towards growth stocks anyway.

So, value, obviously, was the question, and that reversion to value outperformance, which has obviously happened periodically over the last 10 years, but small blips. So, I think a lot of investors have moved away from smart-beta style products for now. But, the market's changing, and I'm sure by the time your listeners hear this, so much other stuff will have happened. We're talking on the Friday after Trump's tariff announcements. There's a big market regime shift, a macroeconomic shift. So, how those other factors will start to perform in that new climate, who knows? But it might mean smart beta returns to interest.

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Sam Benstead: And how do you think the ETF industry in the UK will evolve over the next five years?

Tom Bailey: I think the key thing will be the entry of traditional fund houses into the ETF space. A lot of traditional fund houses have been reluctant to enter the ETF space because they've seen it as an area where you're competing with BlackRock, and Vanguard on scale and price, right? So, why would I want to enter the ETF market and create an ETF, which is going to have to compete with Vanguard and BlackRock? Can I charge three basis points for this S&P 500 tracker? Will that get the money in when the other competitors are charging five or four? So, that's kept fund houses away from the ETF world. They’ve said, what's the point of that? It's such an uphill battle to gain a foothold in it.

But what we're seeing now is this growing awareness around active, and other differentiated products where your USP isn't cost, which is a function of scale. Instead, it's your own IP and your potential or kind of past outperformance, which is a driver of that interest.

So, that's why I think you'll see a lot more traditional fund houses come into the ETF world. At the same time, a lot of traditional fund houses, they want to set up an ETF that's creating a whole new section of the business, but now you have, like with HANetf, these white labellers. So, if you are Jupiter, Guinness, you don't have to go and hire a whole ETF team to set up a new section of the business to focus on ETFs themselves.

Instead, you can go to a white labeller like HANetf and we'll create that product for you. You'll have your branding, your IP, and then if they want HANetf distribution, a mix of it, or they can do their own distribution. So, that ease of access to market has been one of the key drivers of more fund managers and asset managers in the US coming to ETF market, and that is a turnkey solution rather than having to set up your own business.

I think that will be a major feature. When your listeners on the ii platform right now, if they go and look at a lot of the fund houses, they might see there's an investment trust version and there's an open-end version, and they have a choice between the two, whatever they wish. Increasingly, they'll start to see the third arm of that distribution, which is the ETF. So, they have a choice, do they want the ETF version, the trust version, or the OEIC version.

Sam Benstead: And finally, if consumers have that option, why should they choose the active ETF? Can we have two or three reasons?

Tom Bailey: We're neutral on active versus passive, but that varies on which asset class, whichever approach. I think with an active ETF, it's less why I want an active ETF over a passive ETF. I think you're trying to achieve different things there in your portfolio. You have a different perception of markets. You're trying to access different areas of the market, etc.

But instead, our view is why you should use an ETF for your active exposure over an OEIC, or why you should use an ETF for your passive exposure over a traditional index fund.

That comes down to the key reason is that you get that intraday pricing. You pay the price you see on the screen when you click that transact button on ii, and at the same time, that core of fairer cost structure. There is some tax benefit to owning an Irish-domiciled ETF if they own US stocks, which pay dividends. You get better tax treatment on those US dividends if it's an Irish-domiciled ETF than if it wasn't. So, there's also that argument.

At the same time, you'll see a lot of the more innovative new strategies come via ETFs increasingly, like we've seen in the US. And there's also the transparency. So, this is slightly changing, but right now, your ETF has to publish its entire daily holdings. It's not the case with the trust or an OEIC.

In the US, they've changed it, and since 2019, ETFs don't have to publish their daily holdings. But what we've seen is basically 90% of money in active ETFs is going to those fully transparent ETFs still, even though they have the option not to. They can have their non semi-transparent, so not disclose their holdings daily.

The two key regulators for ETFs in Europe, so in Luxembourg and in Ireland, where most ETFs are domiciled, are loosening the rules on this, and they are going allow not full transparency. But I think like in the US, most ETFs will still have that full transparency.

So, I think that's a benefit to investors too. You can go on the ETF issuer's website, and you can see exactly every day what those holdings are in full, not just the top 10. If you go back to, say, February 2022 after Ukraine was invaded by Russia, a lot of investors wanted to know, did they have any Russian exposure in their portfolios, right?

Now with an ETF, you can immediately see that. You can see, OK, there's this Russian stock, this Russian stock, or there's no Russian stocks. With a mutual fund, you're not going to be able to see that immediately.

So that transparency, I think, is quite valued by investors, which is why even though that transparency won't be required in the future in Europe for ETFs, I think it will still be the default way that ETFs are structured.

Sam Benstead: My thanks to Tom, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app, and do tell a friend about it. If you get a chance, leave us a rating or review in your podcast app too. You can join the conversation, ask questions, and tell us what you'd like us to talk about via email on OTM@ii.co.uk.

In the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website at ii.co.uk. And I'll see you next week.

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