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March 31st, 2011 by

What is an Active ETF

At a conference this week, where I was presenting on the topic of Active vs. Index ETF, I was asked what I thought was a simple question: “What makes an Active ETF”?, which I answered, (see discussion below). Interestingly enough, my answer provoked many different responses and created  a very lively discussion during my and the following sessions on the topic and definition of Active ETFs as well as indices. These conversations showed me that Active ETFs are still young and not well understood.

So what does make an Active ETF? The first and most important point is that the level of trading activity does not make an Active ETF active. In fact some ETFs can trade only several times a month or even per quarter and still be considered active.

The second point is that if an ETF follows an index it does not make it a passive ETF (i.e. non active ETF), so we cannot take the inverse of this rule. There is a sleuth of ETF that follow the index, such as “CSM” or “RALS”, both from ProShares. Although they do follow an index, these ETFs are not passive investment vehicles.

In my opinion, what makes an Active ETF is it’s true intention. The true intentions are always hard to decipher, especially when discussing financial strategies. Fortunately the intention can be relatively easy to classify in the following way.

In my classification scheme I would simply ask two questions. First question would be, does the manager follow an index or not.  By default if the manager does not follow an index that means the manager has an investment strategy and thus this would make an Active ETF. Examples of this are “GRV” and “GTAA” from AdvisorShares.

Now if the manager does follow an index, my second question would be, is this index a benchmark or is it a custom made index. So for example a “DIA” follows the benchmark of the Dow Jones 30, so is “MDY” that follows the S&P 400 benchmark. These benchmarks are well defined and are available for public scrutiny. What that means is that we, as investors, in theory can replicate the index ourselves (assuming the trading cost is not an issue). So in the case of Dow Jones 30, we would buy the 30 companies based on the DJ 30 list, that is publically available, one share each. In the second case, we would buy the 400 mid cap companies, as defined by S&P, in the market weighted proportion.

So now, by method of elimination, it is pretty straightforward to classify the rest of ETFs. In other words, if the manager follows a custom made index, that is not public and that is hard to replicate, this manager follows an investment strategy, and thus ETFs based on custom indices are defined as active ETFs.

As a case study example, let’s take “RALS” once again. This is not a judgment of the merits of this product at all (in fact I think it is a very interesting product, see my earlier article), but it is a good example for this specific discussion. This ETF follows an index, so one could assume that any investor can replicate this strategy. This ETF also trades infrequently, may be less than once a quarter, so one could also assume, since there is not much turnover this is a passive investment vehicle. The fact of the matter is that both provide “false positives”. The index is a private quantitative index that is a secret sauce of an investment strategy and it is not disclosed. And the trading is infrequent only because the strategy is based on fundamental weighing methodology which has a low turnover.

In summary if one does want to know if an ETF active or not, I would suggest that you ask the two simple questions I mentioned above.

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