Originally published at: A new generation of ETFs – InvestEngine Insights
Actively managed exchange-traded funds (ETFs) are increasingly popular. But how do active ETFs work, and what makes them so special?
ETFs are investment funds that are traded freely on major stock exchanges. Because ETFs track stock or bond indices, they can provide efficient and highly diversified access to a range of global markets and investment strategies. While many ETFs take a passive approach by aiming to replicate well-known benchmarks, such as the S&P 500 or the MSCI World Index, ETFs can also be actively managed to pursue a specific strategy or investment philosophy.
From passive to active ETFs
In many markets, passive ETF strategies are also known as “exchange-traded index funds”. These ETFs are designed to track the performance of a specific benchmark by investing directly in, or replicating exposure to, all the securities included in the index. This passive index approach allows investors to gain exposure to a particular market, sector or region through just one ETF – without buying every single security in the index. As a result, passive ETFs can save investors a great deal of time and, above all, money.
Active ETFs, by contrast, provide access to specially constructed portfolios that offer investors the chance to potentially earn performance over and above traditional benchmarks, or relative to specific sectors or themes. They use the insights provided by expert security analysts and portfolio managers, who look to exploit inefficiencies in stock or bond indices by allocating more of the portfolio to securities, sectors or markets that are deemed to be undervalued (and, by extension, allocating less to those deemed to be overvalued). Crucially, the ETF vehicle itself provides the same cost-effective and transparent wrapper with which investors can access these active investment strategies.
Why active ETFs can offer higher potential returns
Like passive funds, this new generation of active ETFs is also aware of indexes. But instead of fully tracking the index, the portfolio management team takes small over- and underweights based on the expert research of analysts. But at the same time, the regional or sectoral allocation of the active ETF stays the same like the index, so that from birds eye view, the active ETFs look the same as the index.
The goal is to not just share in the return of the underlying market – known as the beta – but to also generate an additional return beyond the market. This excess return, or alpha, can add up over time, providing investors with the potential for enhanced long-term performance, all while maintaining access to the overall benefits of the ETF structure.
Active investment strategies make it possible, among other things, to target investments with particular environmental, social and governance (ESG) characteristics. Instead of simply excluding certain controversial sectors, active fund managers can take sustainability into account in every investment decision through rigorous stock-level research, and by maintaining dialogue with the companies in which they invest. For example, J.P. Morgan Asset Management’s Research Enhanced Index Equity (ESG) ETFs seek positive alpha by blending active security selection with a low tracking error approach, all within a robust ESG framework.
What does tracking error mean?
Tracking error is the difference between the performance of an investment fund, such as an index fund, and the performance of its benchmark, which is used as a reference. A high tracking error indicates that the fund’s performance varies significantly compared with the benchmark, while a low tracking error indicates that the fund has followed the benchmark relatively closely.
The first active ETF was launched in 2008. There are now 19 ETF issuers offering active ETFs – a number that has tripled in the past five years. The active ETF market is already as diverse as active mutual funds, ranging from index-like, research-enhanced strategies to more focused thematic funds.
More and more investors are using active ETFs to increase their potential returns. (Source: Bloomberg, J.P. Morgan Asset Management)
Good examples of the types of active ETF that are now available include the JPMorgan ETFs (Ireland) ICAV – Global Research Enhanced Index Equity (ESG) UCITS ETF (ISIN IE00BF4G6Y48) and the JPMorgan ETFs (Ireland) ICAV – Global Emerging Markets Research Enhanced Index Equity (ESG) UCITS ETF (ISIN IE00BF4G6Z54). Both of these actively managed equity funds combine fundamental stock research, rigorous analysis of financially material ESG risks and efficient index exposure, with the goal of maximising the potential for alpha generation while minimising uncompensated index risks.
The portfolios are based on well-known regional indices, in this case the MSCI World Index and the MSCI EM Index. From this starting investment universe, companies in certain non-sustainable sectors, such as weapons or tobacco¹, are excluded. Expert portfolio managers then draw on the research output of a global team of sector analysts to take small overweight positions compared to the index in stocks that look attractively valued based on long-term earnings expectations, and small underweight positions in stocks that look unattractive. This approach allows sector and country weights to be kept close to the index, but with the potential for active research to deliver long-term outperformance.
Active ETFs represent an attractive way to strengthen the core of your portfolio, add diversification, or implement tactical investment decisions.
1 Exclusions do not mean that there is no exposure, but rather that companies whose sales in these areas exceed a certain threshold are excluded. The exclusion policy can be found at the J.P. Morgan Asset Management websites.
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