We have received quite a few questions related to the costs and benefits an ETF sponsor faces when managing their funds as a “passive/index fund” versus an “active fund.” Several weeks ago we talk about some of the regulatory & legal nuance tied to Index and Active ETFs and we recommend you read that article for a deep dive.
Please note that the comments in this blog speak to the issue from the perspective of an ETF issuer, not necessarily an ETF consumer. Determining how the different structures might affect investment outcomes is nuanced and beyond the scope of this educational blog post.
What are the key costs and benefits of active versus index ETFs?
Index ETFs might be good for an ETF sponsor because of the following:
- Increased transparency
- Ability to show backtested performance under certain guidelines
- Easier due diligence and quicker onboarding times on to large wirehouse platforms
Active ETFs might be better because of the following:
- Potentially lower costs because an index calculation agent is not required.
- Potentially lower costs because data licensing fees are no longer required.
- Potentially lower costs because compliance burdens tied to managing index compliance are lower.
- Strategy flexibility
- Less intellectual property flight
In summary, there are no right answers when it comes to launching an active or an index ETF. However, the trade-off can be boiled down to the following: Index ETFs come with increased transparency and marketability; Active ETFs come with lower operational costs and increased portfolio management flexibility.
Important side note: The tax efficiency of Index versus Active ETFs, while similar now, were different in the past. In the past, Index-based funds had a potential tax advantage over Active ETFs. This differential tax treatment is no longer a factor and the majority of active/index funds enjoy the same tax benefits regardless of the regulatory structure.
Appendix: Basic background
ETF sponsors, until recently, had to file an exemptive application to the SEC. Why? In order to operate an ETF, a fund sponsor needs to do things that are not allowed based on the Investment Company Act of 1940, so they seek relief from these regulations from the SEC.
There are two primary types of relief:
- Index relief — granted to those fund sponsors that systematically follow a process, or index.
- Active relief — granted to those fund sponsors that can choose to follow an index and/or invest based on their discretion.
In this piece, we will focus on the lawyer’s understanding of active and passive, not the financial definitions. Sorry finance geeks!
What is an Active ETF?
An Active ETF is an ETF structure that offers the portfolio manager a lot of flexibility to achieve their investment objective and the “secret sauce” of their process does not need to be revealed to the world. Active ETF examples could be 100% discretionary stock pickers or 100% automated algorithms. The key difference between Active ETFs and Index ETFs is that these ETFs can change/adapt on the fly and are not beholden to the hard and fast rules of an Index ETF.
What is an Index ETF?
An Index ETF, unlike an Active ETF, seeks to track an underlying index. And the Index MUST BE 100% mechanical. So all rebalances, all algorithms — everything — must be spelled out ahead of time. There cannot be a discretionary aspect to the process and making changes to the Index cannot be made on a frequent basis. Moreover, the details of the process need to be disclosed.