Where Active ETFs Do Not Make Sense

By  Shishir Nigam

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With the number of players entering the Active ETF arena turning from a drip into an outright flood, we are likely to see a much wider variety of products and strategies come to market in the form of actively-managed ETFs. While it’s important to point out the advantages of actively-managed ETFs that has resulted in such an interest in the market, it is also important to understand where they do not make sense and are not as effective a delivery mechanism when compared to traditional structures. Areas where Active ETFs do not work are generally those where the ETF structure in general runs into problems and is no longer able to provide investors with all its benefits. Some of these areas include the following:

International Equities

Unlike an active mutual fund, Active ETFs allow investors to trade the ETF in the market at any point during market hours. This ability is made possible by the market maker who stands behind the ETF and is obliged to provide a bid and ask price to investors looking to trade the ETF. However, to be able to do so, the market maker needs to be able to trade in the underlying securities of the ETF. If these securities trade on foreign exchanges, in different time zones, this means that there could be times when the market on which the ETF is listed is open but the market on which the underlying securities are listed is closed. This would restrict the market maker’s ability trade in those securities and hence their ability to provide a bid/ask price to the investor. There certainly are Active ETFs that are planning to invest in the stocks of foreign companies, however, they are doing it by investing it in ADRs that are listed in North America and therefore avoiding the time zone problem. Hence, if an ETF’s strategy involves investments in securities listed in different exchanges, in different time zones, a traditional fund structure is going to be a better delivery mechanism because it does not need to provide that tradability which an Active ETF does.

Low Liquidity Sectors

For reasons similar to those mentioned above, Active ETFs that intend to invest in sectors which have securities with very little liquidity will also face problems. For example, if an Active ETF’s portfolio manager intends to invest in small-cap stocks which may not be frequently traded and are illiquid, this could again create problems for the market maker. If there is not enough activity in those small-cap stocks that the portfolio manager invests in, then the market maker will not be able to trade in those securities to effect the trades being put in by investors in the ETF. Hence, as with international equities, strategies involving investments in low liquidity sectors are likely better off being “housed” in a fund structure than an ETF structure.

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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