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Active ETFs Do Not Compete with Index ETFs

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When comparisons are made between actively-managed ETFs and their competitors, they are often compared with their passive counterparts. The 4 pillars of the ETF structure that gives it such an advantage is their liquidity, tax efficiency, transparency and of course low cost. The argument is made that Active ETFs are deficient to Index ETFs because they are usually more costly, less tax efficient because of more trading costs, and less transparent because active managers are reluctant to disclose their holdings.

Those arguments may be accurate, but here’s where I feel there is a disconnect. Just because they are “housed” in the same ETF structure, doesn’t mean that Active ETFs are direct competitors of Index ETFs. Actively-managed ETFs compete with Index ETFs to the same extent that stocks in general compete with bonds for investor’s money. Investors who are looking to pursue an equity investment strategy will only be choosing between equity securities and not look at bonds and vice versa for those pursuing a fixed-income strategy. Yes, these two strategies compete in general for investors’ money but that makes them indirect competitors and not direct ones, like one stock versus another. Likewise, investors who are looking to purse an active management strategy believe that markets are inefficient and will look for actively-managed products instead of passive products. By implication, the main competitors that Active ETFs face are actively-managed mutual funds and not passively-managed Index ETFs because they are two entirely separate strategies.

As in the case of stocks versus bonds, yes, in general Active and Index ETFs compete for investors’ money. Hardly any investor’s portfolio is entirely active or entirely passive. When the mispricing of securities in the market declines, you’ll see money flow to passive strategies, and when you see mispricing rise, money will flow to active strategies. Both strategies have their place in the market, and we’re not going to see either one disappear anytime soon because it is the active strategies that reduce mispricing so that markets are efficient enough to justify the existence of passive strategies. Instead, competition lies WITHIN each of those investment strategies as investors look to find the best structures to express their active or passive views on the market.

With that in mind, it becomes clear why Active ETFs could experience some exponential growth from here on. Because when compared to their actual competitors, actively-managed mutual funds, Active ETFs are indeed more liquid, they are more tax efficient, they are more transparent and they are lower cost.

Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.

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