How Active ETFs Work?

Definition

An Active Exchange-Traded Fund (Active ETF) is a type of investment fund that trades on a stock exchange like a traditional ETF but is actively managed by portfolio managers. Unlike passive ETFs that track a specific index (such as the S&P 500), active ETFs seek to outperform a benchmark through active security selection, timing, and strategic allocation.

Active ETFs combine the flexibility and liquidity of traditional ETFs with the strategic oversight of mutual fund-style active management. They’re growing rapidly in popularity among investors seeking a hybrid of cost efficiency, transparency, and potential alpha generation.

How It Works

Structural Overview

Active ETFs share much of their basic structure with traditional ETFs:

• Listed and traded on major stock exchanges
• Priced throughout the day (intraday liquidity)
• Can be bought and sold like stocks
• Usually require lower minimum investments than mutual funds
• Offer tax efficiency through in-kind redemption

However, the key difference lies in the portfolio strategy and disclosure rules.

Active Management Strategy

Active ETFs employ a fund manager or team that:

• Selects securities based on research, outlook, or proprietary models
• Adjusts portfolio composition in real time as market conditions change
• May use sector rotation, macroeconomic analysis, fundamental research, or technical indicators
• Seeks to beat a benchmark, not merely track it

Unlike index ETFs that replicate holdings passively, active ETFs may hold fewer securities, make more frequent trades, and even hedge risk with derivatives or cash positions.

Transparency Models

One of the defining debates around active ETFs has been portfolio transparency.

There are two primary models:

1. Fully Transparent Active ETFs
   • Disclose daily holdings like traditional ETFs
   • Common among equity-based strategies
   • Example: ARK Innovation ETF (ARKK)
2. Semi-Transparent / Non-Transparent Active ETFs
   • Disclose holdings quarterly or monthly, not daily
   • Use proxy baskets or “custom baskets” for in-kind transactions
   • Allow managers to protect intellectual property (trade secrets)
   • Example: JPMorgan Equity Premium Income ETF (JEPI)

The second model is ideal for strategies where front-running or imitation is a concern.

In-Kind Creation/Redemption

Active ETFs, like index ETFs, use an in-kind mechanism:

• Authorized Participants (APs) exchange securities for ETF shares
• This reduces capital gains events within the fund
• Helps preserve tax efficiency, even with higher portfolio turnover

Some semi-transparent models use proxy baskets to mimic this process while concealing exact holdings.

Use Cases / Examples

Example 1: Active Stock Selection

An active ETF focused on small-cap U.S. stocks may screen for undervalued companies, apply qualitative filters, and adjust sector exposure monthly. The fund manager believes that human insight can outperform a passive small-cap index.

Example 2: Covered Call Strategy

Some income-oriented active ETFs (e.g., QYLD, JEPI) use covered call writing to generate yield. These strategies require daily oversight and tactical adjustments, which aren’t feasible in an index-tracking model.

Example 3: ESG or Thematic Plays

Active ETFs allow portfolio managers to apply non-formulaic filters, such as ESG screening, or to bet on themes like AI, blockchain, or clean energy, based on evolving research rather than strict index rules.

Advantages and Disadvantages

Advantages

✅ Potential for Outperformance (Alpha):

• Fund managers can respond dynamically to changing markets

✅ Tax Efficiency:

• Like traditional ETFs, active ETFs use in-kind transactions

✅ Intraday Trading:

• Can be bought or sold throughout the day at market prices

✅ Lower Costs than Active Mutual Funds:

• Expense ratios often fall between index ETFs and mutual funds

✅ Access to Complex Strategies:

• Covered calls, downside protection, long/short, or factor tilts

Disadvantages

❌ Higher Fees vs Passive ETFs:

• Active management comes with higher operating expenses

❌ Tracking Error Is Irrelevant — But Underperformance Isn’t:

• Active ETFs don’t aim to replicate an index; results vary widely

❌ Semi-Transparent Models Can Be Confusing:

• Investors may not always know what they own day-to-day

❌ Performance Depends on Manager Skill:

• No guarantees of outperformance

Tax Implications

One of the strongest selling points for active ETFs is that they retain the tax efficiency of traditional ETFs, even if they trade more frequently than index ETFs.

• Capital gains are minimized through in-kind transactions
• Investors owe taxes primarily on:
  • Dividends
  • Capital gains upon sale
• Compared to active mutual funds (which often distribute gains yearly), active ETFs help defer tax liability, maximizing compounding.

However, if the ETF trades high-turnover strategies or generates frequent income (e.g., monthly covered calls), this income may be non-qualified and taxed at ordinary income rates.

Active ETFs vs Passive ETFs vs Mutual Funds

Feature	Active ETF	Passive ETF	Active Mutual Fund
Management Style	Active	Passive	Active
Trading Flexibility	Intraday (like stocks)	Intraday (like stocks)	Once daily (end of day NAV)
Fees	Medium	Low	High
Tax Efficiency	High	High	Low
Transparency	Daily or delayed	Daily	Quarterly or less
Performance Goal	Outperform index	Match index	Outperform index
Accessibility	No minimums (most brokers)	No minimums	May have $1,000+ minimums

Real-World Examples

• ARK Innovation ETF (ARKK):
  A fully transparent active ETF investing in disruptive innovation. Cathie Wood, the fund manager, actively shifts holdings.
• JPMorgan Equity Premium Income ETF (JEPI):
  Uses a covered call strategy and rotates holdings based on income outlook and market conditions.
• Avantis U.S. Small Cap Value ETF (AVUV):
  Factor-based, actively managed fund with exposure to small, undervalued companies. Transparent and low-cost relative to other active funds.
• BlackRock U.S. Equity Factor Rotation ETF (DYNF):
  Rotates exposure among value, momentum, quality, and other factors based on market conditions.

Growth of Active ETFs

Active ETFs are gaining traction:

• Over $500 billion AUM globally (and growing)
• Major firms like Fidelity, JPMorgan, T. Rowe Price, ARK, and Capital Group are launching active ETFs
• Suitable for both retail and institutional investors
• Especially strong growth in income strategies, thematic investing, and ESG

The shift is driven by:

• Desire for tax efficiency
• Increasing acceptance of ETF wrapper over mutual funds
• Technological improvements in basket construction and disclosure

Related Terms

• Alpha: Excess return over a benchmark
• Beta: Market sensitivity of a fund
• Smart Beta ETF: A hybrid strategy that applies factor tilts passively
• NAV (Net Asset Value): The per-share value of the fund’s underlying assets
• Authorized Participant (AP): Institutional trader who creates/redeems ETF shares
• Factor Investing: Strategy based on specific attributes like value, size, or momentum
• Intraday Liquidity: The ability to buy or sell an ETF during market hours
• Expense Ratio: Annual cost of managing the fund as a % of assets

Conclusion

Active ETFs represent the next evolution in fund investing — combining the best elements of ETFs (liquidity, transparency, tax efficiency) with the strategic potential of active management. They’re especially appealing to investors who:

• Seek to outperform the market
• Want to retain tax efficiency
• Prefer tactical or income-generating strategies
• Are comfortable with higher fees in exchange for potential alpha

That said, not all active ETFs outperform, and they require careful due diligence. Investors should analyze the fund’s:

• Track record
• Manager credentials
• Strategy consistency
• Fee structure

As the ETF industry continues to evolve, active ETFs are likely to take up a larger share of new product launches, especially in niche, thematic, and income-generating categories.