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T here are two major schools of thought underlying portfolio management strategy. One favors an active strategy, the objective of which is to achieve a rate of return that surpasses a given benchmark; the other favors a passive strategy that aims not at beating a selected index but rather at matching its returns. The debate between active and passive management is anything but new: It has spanned several decades and is still going strong.
Although exchange-traded funds (ETFs) were designed mainly to be a passively managed strategy and they essentially continue to reflect that investment philosophy, it was only a matter of time before the active versus passive discourse spilled over into the ETF market. Some fringes of the ETF market clamored for actively managed ETFs since shortly after the advent of their passively managed counterparts, heartened by the fact that this longstanding argument did not prevent the mutual funds industry from turning into a hotbed of active management.
After taking the time deemed necessary to study this new operational structure, the Securities and Exchange Commission (SEC) finally granted its approval to actively managed ETFs, thereby expanding investors' choices for deriving investment returns from the ETF market. This article takes a close look at this market structure, especially with regard to fund transparency. It also examines the market evolution of active ETFs, from the launch of the first active ETF to a thorough assessment of the current crop, in terms of both their return and risk, employing statistical tools frequently used to assess performance. This performance analysis is conducted on the six asset categories covered by active ETFs to distinguish those that display the best risk-return characteristics. We then identify and rationalize the factors driving active ETF performance, drawing meaningful inferences regarding the market acceptance and future outlook of active ETFs.
THE DEBATE OVER ACTIVE VERSUS PASSIVE MANAGEMENT
Market efficiency widely supported by the academic community is at the heart of the active-versus-passive discussion, as will be discussed in the following sections.
The Academic Argument
The chief corollary behind the academic argument that markets are efficient is the belief that price movements do not follow any patterns or trends; rather, prices follow a random walk,1 an intrinsically unpredictable pattern. Predictable stock-price movements would...