Active ETFs See Rapid Growth Amid High Performance Concerns

Investors have been flocking to actively managed ETFs, with their assets under management growing five times more than those of passive funds in 2024, according to a report by Morningstar. As these funds chase high performance, analysts have raised concerns about whether the higher returns justify the increased expenses and risks.

"Active funds add an extra layer of risk that doesn't always translate to returns, especially considering their higher fees," said Roxanna Islam, head of sector and industry research at financial data and insights platform TMX VettaFi.

Active ETFs, which aim to outperform benchmark indexes, typically have higher expense ratios than their passive counterparts that track market indices and require less management. Data from Morningstar indicates that active ETFs have an average management fee of 0.63%, compared to 0.44% for passive funds.

Don Calcagni, chief investment officer at Mercer Advisors, noted, "They're typically slightly more expensive than traditional passive ETF vehicles, and investors will likely struggle to understand what they're getting in return for those slightly higher fees." He added that active ETFs necessitate more investment training and sophistication for effective execution.

Market observers reported that active ETFs may perform better under uncertain or volatile market conditions, where skilled management can add substantial value. In comparison to active mutual funds, which have an average fee of 1.02%, active ETFs are relatively cheaper. The average annual return over a five-year period for active ETFs in the U.S. stands at 5.57%, while passive ETFs yield 4.27%, according to Morningstar data.

Despite their seemingly attractive outperformance, there are additional costs to consider. Gareth Nicholson, chief investment officer at Nomura's international wealth management team, pointed out that while active ETFs are more economical than mutual funds, they often have wider bid and ask spreads, particularly for newer funds. A wider bid-ask spread indicates lower liquidity, which can lead to higher transaction costs for traders.

"These unseen trading costs can eat into returns," Nicholson stated. Active ETFs, which trade in real-time, are also more vulnerable to market fluctuations, unlike mutual funds that price once daily.

Similar to mutual funds, only a small percentage of active ETFs consistently outperform their benchmarks. Data from Morningstar revealed that the average alpha, or outperformance compared with peers, delivered by U.S. active ETFs in 2024 is in the negative, at -1.34%. A particularly high-risk class of active ETFs is single-stock funds, where, following a sharp decline in Nvidia shares last month, single-stock leveraged ETFs betting on the company's growth experienced record single-day losses of over 33%, emphasizing the risks associated with active strategies.

"Leverage amplifies volatility—when markets move against you, losses are magnified," Nicholson explained, noting that leveraged ETFs fall under active management and are intended to deliver twice or thrice the performance of a specific stock on a single-day basis, but losses are also similarly exaggerated.