Getting active with ETFs

Active exchange-traded funds (ETFs) represent a complex fusion of the traditional advantages of ETFs with the potential value add of active management. Initially, ETFs were nearly entirely passive vehicles, tracking indexes (usually weighted by market capitalisation) with no discretionary input from fund managers. However, active ETFs have emerged as a significant innovation, blending active management within an ETF framework. This allows fund managers the ability to exercise discretion, making investment decisions without strict reliance on index-based strategies. The increase in active ETFs shows that investors are choosing to invest in vehicles that are open, flexible, manage costs well and work efficiently. These vehicles also have the added benefit of professional investment oversight and may perform better than other investments.

The concept of active ETFs first appeared in 2008. However, adoption was slow due to both the prevailing financial crisis and a lack of familiarity with the structure’s unique advantages. For many investors, passive ETFs remained a staple due to their simplicity, low costs and transparency, while active management was largely the domain of mutual funds. Yet, in the 2010s, demand began to shift as investors sought dynamic investment options capable of potentially outperforming standard index returns.

At Franklin Templeton, we launched our first active fixed income UCITS ETFs in 2018 and subsequently broadened our range. While active ETF assets are still small compared to those in passive vehicles, the segment is experiencing significant growth: active ETFs represented just 1.8% of total assets in Europe’s ETF market at the end of 2023, yet asset growth was 28%—over three times the rate of the wider market.¹ This trend has continued in 2024, with active ETF assets globally comprising 7% of the market yet capturing 25% of flows as of June 2024.^2,3

It is worth noting, however, that not everything labelled an ‘active ETF’ fits the bill precisely. The term is not certified or protected, and what defines ‘active management’ is, to an extent, subjective. At Franklin Templeton, we take a hands-on approach to active management, driven by a dedicated team of analysts, researchers and fund managers who cultivate strong relationships with investee companies and maintain deep market expertise. Our active ETFs involve this team of experts conducting thorough research, engaging with company management, and making discretionary decisions within set investment guidelines. This approach allows portfolio managers to identify market inefficiencies and potentially generate alpha, adding value beyond simple index replication. In fixed income, value creation often stems from strategic duration management, sector allocation and security selection, especially as fixed income indexes tend to prioritise the largest issuers rather than those with the highest value or creditworthiness—a scenario that experienced managers can exploit effectively.

In equities, a third category of ETFs straddles the line between active and passive approaches. These factor-based ETFs employ predefined characteristics—such as quality, value,⁴ momentum or low volatility—to select and weight stocks rather than adhering to a traditional market-cap-weighted index. While these ETFs follow an index, they incorporate the philosophy of active management in factor selection and portfolio construction, attracting investors interested in capturing market inefficiencies through a rules-based approach.

Shifts in investor behaviour and regulatory developments have also driven the rise of active ETFs. Investors today prioritise flexibility and seek granular solutions that can adapt to market conditions. In fixed income, we believe the current market environment presents some of the most favourable opportunities for active managers seen in recent years, if not decades. With high interest rates, gradually declining yet sticky inflation, central banks like the US Federal Reserve (Fed) and European Central Bank (ECB) beginning to pivot and uncertainties tied to geopolitical and technological shifts, investors may extract attractive nominal yields and use volatility to add value through targeted portfolio construction. Experienced managers are well suited to navigate these complexities, offering a compelling option for investors balancing cost efficiency with professional oversight. Active ETFs can also serve as alternatives or complements to actively managed mutual funds that lack the liquidity and transparency advantages inherent in ETFs.

Like their passive counterparts, active ETFs have different applications across retail and institutional portfolios. A primary use is in portfolio diversification, as active ETFs can provide access to sectors, themes, or investment styles that may be under represented in traditional index ETFs. For example, an active ETF targeting green bonds enables investors to access this relatively new market segment while also adding potential value. Green bonds are labelled at the security level rather than the corporate level, allowing companies to issue green bonds for specific projects even if their overall operations are not aligned with climate transition goals. An active manager can delve into these intricacies and may choose to exclude a green-labelled bond if they deem the issuer’s environmental policies, safeguards or broader practices insufficient. A passively managed ETF, of course, would be required to hold the bond if it is part of the index it tracks.⁵ The strong growth of the European green bond market from virtually zero to close to one trillion euros in 10 years, coupled with increasing issuer diversification, further supports the case for active management in the segment.

The growth of active ETFs is evident in the rapid expansion of offerings by major asset managers, driven in part by a highly competitive landscape. With fees in the passive ETF sector continuing to compress, asset managers are turning to active ETFs as a means of differentiation. About half of Europe’s ETF issuers now offer actively managed ETFs.⁶ Out of nearly 2,000 ETFs, roughly 120, or 6%, are listed as active ETFs, according to Bloomberg. The outlook for active ETFs is positive, with significant growth expected over the next decade. Increased adoption by institutional investors, drawn to the liquidity and cost efficiency of ETFs, is one trend underpinning this expansion. For institutional portfolios, the opportunity to integrate actively managed components without compromising transparency or cost control is very compelling.