How to know if actively managed exchange-traded funds are right for your portfolio

Exchange-traded funds are often associated with passive strategies. But money has also poured into the actively managed version of ETFs, as investors crave more precision, experts say.

While passively managed ETFs aim to replicate an index, such as the S&P 500, active managers are more hands-on, trying to outperform a specific benchmark.

Active ETF managers may routinely “check under the hood” with a process-based approach, said certified financial planner Jon Ulin, managing principal of Ulin & Co. Wealth Management in Boca Raton, Florida.

Actively managed U.S. ETFs jumped to nearly $275 billion in net assets in September, up from about $140 billion the previous year, according to Morningstar data, making up just over 4% of the overall U.S. ETF market.

Experts say there are several reasons for the explosive growth.

“I think the one common thread among a variety of different things is that ETFs are becoming the vehicle of choice for a larger number of investors,” said Ben Johnson, director of global ETF research for Morningstar.

One of the biggest selling points of ETFs over mutual funds is cost, and active ETFs are no exception.  

Typically, ETFs are less expensive than mutual funds, averaging 0.62% in fees, according to Morningstar, compared to 0.71% for an active stock mutual fund, the Investment Company Institute reports.

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“Over the past year, we have pivoted a good bit of our client model portfolio holdings from mutual funds to ETFs to reduce investment expenses and help to lower taxes in non-retirement accounts,” Ulin said.

Of course, active ETF fees may be higher than equally-weighted passive ETFs, which average 0.41%, according to Morningstar.

Active ETFs may appeal to investors looking for more precision than passive investments. 

“Managers have the flexibility to use their processes, knowledge, research and tools to find who they believe will be the best-performing companies in a particular sector,” said CFP Ashley Folkes, a financial advisor and director of marketing and growth strategies at Bridgeworth Wealth Management in Birmingham, Alabama. 

Moreover, they can potentially help lower risk, increase returns or smooth out volatility, according to Ulin at Ulin & Co. Wealth Management.

However, like all active funds, the performance varies depending on the manager. And some advisors prefer the rigor of managing portfolio assets themselves.

“The disadvantage [of ETFs] are you’re hunting with a shotgun, not a rifle,” said Harlan Cadinha, chairman and chief strategist of Honolulu-based Cadinha & Co., which ranked 90th on CNBC’s FA 100 list for 2021.

Another benefit of actively managed ETFs over mutual funds is tax efficiency.

While ETFs and mutual funds are both baskets of assets, investors typically receive more taxable income from mutual funds, due to differences in fund structure and the rebalancing process. 

As mutual fund managers buy and sell assets, it creates capital gains for the investor — including short-term gains taxed at less favorable rates — depending on when the transaction happens.

“You’re at the mercy of the [mutual] fund manager in so far as taking gains,” Cadinha said.

However, ETF money goes into so-called “creation units,” shielding everyday investors from the ETF gains when the underlying assets are bought and sold.