Actively Managed ETF: Meaning, Overview, Limitations

What Is an Actively Managed ETF?

An actively managed ETF is an exchange-traded fund with a manager or team making decisions on the underlying investments in the fund. Often, an actively managed ETF tracks a benchmark index, but managers may change sector allocations, market-time trades, or deviate from the index as they see fit to try and meet the fund's objectives.

How an Actively Managed ETF Works

An actively managed ETF features many of the same benefits of a passively managed exchange-traded fund, like price transparency, liquidity, and tax efficiency, but with a fund manager that can adapt the fund to changing market conditions. The combination of active management and an ETF provides investors with an innovative solution to asset management.

For investors, there is enough to like about actively managed ETFs, such as lower expense ratios than mutual funds and the active participation of seasoned financial professionals. Because these funds only employ highly experienced and proven managers, there is a possibility of gaining benchmark-beating returns.

There are no guarantees that an actively managed fund will underperform or outperform a passive ETF rival, even with the skills of the managers. Traditional ETFs can at least be counted on to follow an index faithfully, which allows investors to know the holdings and risk profile of the fund. This helps keep a diversified portfolio in line with expectations.

Fund managers of an active ETF, however, have the freedom to trade outside of a benchmark index, which makes it more difficult for investors to anticipate the future makeup of the portfolio. This can work for investors when market conditions experience heavy volatility. An active manager can shift allocations away from underperforming positions to more appropriate sectors or asset classes.

Limitations of an Actively Managed ETF

Although actively managed ETFs share many characteristics of passive exchange-traded funds, they tend to come at a premium. Many have higher expense ratios than passive index ETFs, which puts pressure on fund managers to work hard to outperform or beat the market.

As with an actively managed mutual fund, the potential to outperform comes down to the manager's abilities. Some will regularly beat expectations, but most research finds active management to underperform a passive strategy.

Furthermore, actively managed ETFs tend to contradict basic investment principles like diversification. The typical fund manager shifts allocations according to market conditions, meaning the fund may be less diversified than a passive ETF.

The Bottom Line

Actively managed ETFs are investment vehicles that pool funds and hold a basket of assets while focusing on a specific strategy, such as ETFs that hold covered calls. When an asset fails to meet performance goals, the managers swap it for another, better-performing asset to ensure the fund maintains its returns.

Fees are generally higher in actively managed ETFs because of the activity involved, but this doesn't mean they're not appropriate for an investor's goals. If the fund's performance outweighs the fees, it might be an attractive opportunity for someone who can afford it or doesn't mind paying more for better performance. Conversely, the higher fees can eat into returns, so investors who can't afford them or don't want to pay more should avoid them.