How to Navigate the Evolving ETF Landscape

Emergence of Active Funds

Historically, many investors have used the terms "ETF" and "passive investment" synonymously. This is understandable, because the vast majority of ETFs have historically been passively managed. 

However, in recent years we have seen many actively managed ETFs come to market. Active ETFs saw inflows of over $200 billion in the first eight months of 2024 (about a quarter of overall ETF inflows) and are on track to capture $4 trillion assets under management by 2030.

With active ETFs poised for explosive growth, it is increasingly important that advisors are well-informed of the benefits that active management provides. While passive ETFs are typically low-cost options designed to track market indexes, active ETFs offer the potential for outperformance. Many investors who have historically favored active strategies for their potential to outperform an index or provide downside protection are increasingly able to seek these types of strategies within the ETF vehicle.

Evaluating Investment Strategies

Given the rapid growth of ETFs, advisors must be diligent in selecting the right products for their clients. Some considerations apply to both active and passive ETFs. 

For instance, it's important to consider an ETF's liquidity — its ability to be bought or sold efficiently. Surface-level indicators of an ETF's liquidity include its average trading volume, size and bid-ask spread. But it's also important to consider additional liquidity that can be sourced from an ETF's underlying basket of securities. This can be quantified as "implied liquidity," a helpful metric to understand what amount of an ETF's shares could potentially be traded based on the liquidity of its underlying securities. 

It is especially important to consider this forward-looking estimate of liquidity for smaller ETFs that may not be traded as frequently. 

When selecting passive strategies, investors should evaluate whether an ETF is able to provide the desired exposure by closely tracking its index. Investors should also be cost-sensitive when choosing passive investments that seek broad market exposure because there are often multiple ETFs that may provide similar market exposures before fees. 

When selecting active strategies, cost is important but should be considered relative to the value that the investor believes an active manager can generate. Investors should evaluate whether an ETF's issuer and strategy possess characteristics that have been supported by academic research as being associated with future outperformance.

Matt Barry is vice president of product management and head of capital markets at Touchstone Investments.