A guide to unlocking the power of active ETFs

Key takeaways

• Active ETFs versus passive ones
• Five different active ETF strategies and their advantages
• Tips for choosing between strategies
  

What are active ETFs?

Exchange-traded funds (ETFs) are like the ultimate investment buffet. When you buy an ETF, you immediately own a small slice of each of the many stocks or bonds it contains. And you don’t even need to leave the house for this feast: ETFs trade on stock exchanges, so you can buy and sell them just like an individual stock.

You can cut and slice them a few ways, but there are broadly two types of ETFs: active and passive.

A passive ETF buys you a slice of an entire stock market. See, these funds aim to replicate the performance of the corresponding market index by using a buy-and-hold strategy – hence the “passive” label.

Active ETFs, on the other hand, seek to outperform the market. So instead of simply tracking an index, these funds have managers who buy and sell holdings at certain times in an effort to make market-beating returns.

Both types get you instant portfolio diversification with minimized volatility. Active ETFs, in particular, unlock asset classes besides stocks, and more complex investment strategies usually exclusive to institutional investors. For you, that’s a chance to potentially outperform the market while still investing in line with your individual goals. Better still, they cost a lot less than mutual funds or implementing the strategies yourself.

Let’s see how they work in practice:

Thematic ETFs

If you prefer more focused, specific investments, then you might like thematic ETFs. They invest in a basket of assets related to a specific theme or trend – say artificial intelligence, sustainability, digitization, or even K-pop. While the theme’s locked in, the ETF tracks various suitable firms in different industries to keep your lot diversified. Just bear in mind that trends can often turn out to be fads or take years to play out.

You can usually find a few ETFs related to the same theme. Look through the fund’s top-ten holdings or its diversification across sectors and countries to work out which one best fits your portfolio.

Multi-asset ETFs

These ETFs provide low-cost diversification by investing across a variety of asset classes like stocks, bonds, and real estate trusts. Returns tend to be smoother with this tactic: when one asset class dips, another will probably pick up. You’ll choose the level of risk you want: conservative, balanced, or growth. The higher the risk, the higher the expected return. And the ETF’s composition will duly reflect that. For example, a growth multi-asset ETF might hold higher-risk bonds and stocks, or be weighted toward volatile stocks over stable bonds.

You can combine this approach with thematic investing, say by picking an ESG-focused ETF that invests in sustainable stocks and green bonds.

Inverse or leveraged ETFs

Stocks might be easy to buy, but they can be tough to sell or short – especially if you’re fairly new to the game. But some ETFs actually let you sell an index. They’re called inverse ETFs, and they aim to provide returns that are the opposite of the performance of an underlying index, sector, or asset class. Essentially, a bet against them. More pessimistic investors might like these, or anyone with a strong short-term view of the market’s direction.

Leveraged ETFs are a bit different. They use financial derivatives – think futures contracts, options, and swaps – to amplify your returns. So without putting down a bigger outlay (the amount it costs to make your trade), a 2x leveraged ETF could deliver double the daily return of its underlying index. Be wary, though: leverage works in reverse, too, so your losses would be magnified as well. For example, prices only need to fall by a third for a 3x leveraged ETF to lose everything. You need a high risk tolerance for this, so they’re probably best for more experienced investors.

Options-based ETFs

Options are basically contracts that give you the chance to buy or sell an asset at a set price before a specified deadline. That’s handy if you have a short-term idea about where an asset’s price might go. "Call" options let you buy and "put" options let you sell. Either way, though, you don't actually own the underlying asset you're dealing with.

Since options are extremely flexible, you can use them alongside your investments. That way, you can double down or protect your existing positions, and even generate extra income by selling these contracts.

A bunch of ETFs use options, all in different ways. Covered call ETFs are a smart example. They're quite complicated, but they essentially take out opposing bets in a bid to net some tidy income. Yearly returns can hit 12% with these trades, but there's a catch. See, if markets shoot past a certain point, your potential profit stops growing. These work best in volatile markets, specifically ones without consistent major moves in one direction.

Here’s what a covered call ETF’s payoff profile looks like:

If you’re an income investor and don’t mind forgoing the upside potential of markets, you might want to explore covered call ETFs. If you’re risk-averse and worried about markets tanking, maybe consider put-writing ETFs: they put a floor under prices.

Buffer ETFs

Buffer funds, commonly known as defined-outcome funds, are linked to an underlying asset like a stock market. Their goal is to offer a predetermined performance pattern over a set timeframe – known as the "outcome period" – which could span one or two years. And their biggest advantage: they have a built-in safety net to protect against market drops, usually around 10% to 15%.

When the pre-defined outcome period ends, the performance of the underlying asset will be assessed. That’ll shape the fund’s value and, in turn, your payout. Buffer ETFs might be a nice fit if you’re risk-averse, keen on stability, or nearing retirement.

Here’s what a buffer ETF’s payoff profile looks like:

Notes to remember:

Active ETFs are versatile, adaptable, and can accurately reflect your more specific investment views. Because they include multi-asset strategies, their returns are generally uncorrelated to markets, making them a good source of diversification. But since a lot of active ETFs are short-term trades, they shouldn't be the main star of your portfolio. Instead, you might want to use them alongside longer-term passive market index ETFs.

Active ETFs tend to be pricier than passive ones, but they're still cheaper than mutual funds. And note that since a lot of them are fairly new, you won’t have a huge amount of historical data to check. Plus, you’ll need to put in some time to stay on top of them. Finally, they work best if you have a strong market view, so you may want to test your hypotheses before you dive in.