Adding active semi-transparent ETFs to a portfolio
The rise of active semi-transparent (or nontransparent) exchange-traded funds (ST ETFs) has given investors another tool to help them meet their long-term goals. These relatively new ETFs combine many of the same benefits of index ETFs with active management—but knowing where they fit into a portfolio can help investors understand the role they can play.
Building a portfolio for any investor entails matching their long-term goals and risk tolerance with investment products designed to get them there. ETF use has exploded over the last decade as they have offered low-cost market access along with liquidity. Because of this, many investors use ETFs as building blocks in their portfolios. But active ST ETFs can serve an entirely different purpose in a portfolio than a traditional index ETF.
A growing tool in the ETF arsenal
ETFs have expanded dramatically over the last decade to more than $6 trillion in assets under management (AUM) industry-wide. Advisors, individual investors and institutions use ETFs primarily to gain low-cost, efficient market exposure to a desired segment of an asset class, ranging across equities, fixed income, commodities and even alternative investments. In 2022, flows into ETFs remained strong at over $500 billion despite the significant market volatility and draw downs.
Record annual flows in 2021 and 2022
Source: Morningstar Direct as of 12/31/22
Like many active mutual funds, active ST ETFs tend to seek to outperform the broad market or a market segment by applying active decision-making to the investment process. But they also maintain many of the benefits of ETFs, including intraday trading and the potential for tax efficiency.
Active ST ETFs are still a relatively small but fast-growing portion of the overall ETF market. Within a portfolio, the role of an active ST ETF is also different than an index ETF. As advisors work with their clients to determine their goals and risk tolerance, many use index ETFs as the building blocks or core holdings of a portfolio. To generate alpha or income, advisors have typically used other vehicles but now can consider active ST ETFs for these objectives.
Active or passive? How about both.
Much has been made about the industry’s shift to passive over the last decade. Hundreds of billions have flowed into passive ETFs, primarily, while billions have flowed out of active mutual funds for many years. Investors have been drawn to ETFs’ liquidity, costs, transparency and potential tax efficiencies.
The potential benefits of active ETFs
Active ETFs (both transparent and newer active ST ETFs) can play an important role in any portfolio. The role of active ETFs in a portfolio could vary from seeking higher returns to mitigating risk and even aligning with personal values. Some active strategies are designed to “lose less” than a benchmark, which can help smooth returns when markets are volatile by avoiding steep downturns. Other active strategies may seek to align investments with Environmental, Social and Governance (ESG) principles. By investing in an active ETF, investors can access the experience and acumen of skilled active managers at a potentially lower price point than a traditional active mutual fund. Investors can also choose how they want to allocate their active strategies, whether that is in “efficient” asset classes such as U.S. large cap equities or in other pockets of the investment universe, such as factor or ESG.
Complementing portfolios with active ETFs
Building an optimal portfolio can include taking some measure of risk to generate growth while also building in protection for inevitable market downturns. Advisors can draw from model portfolios or other “pre-cooked” asset allocation frameworks to address the varying risk profiles of their clients. It’s important to note that the addition of active ETFs may change the risk/return calculus for any investor.
Return expectations can vary widely depending on the strategy, manager and asset class of an active investment. Knowing how a fund fits into a portfolio lineup can be crucial to avoiding investment overlap and understanding how it may alter a portfolio’s risk profile. Considering how these products fit together in an investor’s portfolio is key to helping them stay aligned with their long-term goals.
Active ETFs typically reside in the active sleeve of a portfolio. Investors may decide to focus on alpha or return-seeking strategies in less efficient markets, or perhaps as risk mitigators, potentially offering downside protection during volatile periods.
Recognizing the opportunities for active ST ETFs
The active ST ETF structure opens up a wider breadth of portfolio strategies inclusive of portfolio managers who need the ability to cloak their portfolios to implement their proprietary approaches. So where do active ST ETFs fit in?
At a very basic level, portfolio construction seeks to match asset class exposures to an investor’s goals, objectives, risk tolerances and personal circumstances. The foundation of any portfolio is the core exposures. For most investors, that means stocks and bonds and perhaps gold or real estate. Investors may also choose to invest in non-core strategies to generate potential alpha, income or perhaps investments that match their personal values such as ESG. An active ST ETF may serve in any of those roles.
The most compelling opportunities, however, may also lie in solutions-based strategies such as dividends and absolute return, or in inefficient corners of the market such as small cap, or systematic-tilting such as quality, value or growth, among others.
The role of active ST ETFs can include pursuing outperformance, adding diversification, aligning with investors’ personal values or a combination of these. Having the choice to add an active ST ETF may help investors achieve a more optimal allocation while also offering the potential for market-beating returns.
What makes the Schwab Ariel ESG ETF different from traditional ETFs?
Traditional ETFs tell the public what assets they hold each day. This fund will not. This may create additional risks for your investment. For example:
- You may have to pay more money to trade the fund’s shares. This fund will provide less information to traders, who tend to charge more for trades when they have less information.
- The price you pay to buy fund shares on an exchange may not match the value of the fund’s portfolio. The same is true when you sell shares. These price differences may be greater for this fund compared to other ETFs because it provides less information to traders.
- These additional risks may be even greater in bad or uncertain market conditions.
- The ETF will publish on its website each day a “Proxy Portfolio” designed to help trading in shares of the ETF. While the Proxy Portfolio includes some of the ETF’s holdings, it is not the ETF’s actual portfolio.
The differences between this fund and other ETFs may also have advantages. By keeping certain information about the fund secret, this fund may face less risk that other traders can predict or copy its investment strategy. This may improve the fund’s performance. If other traders are able to copy or predict the fund’s investment strategy, however, this may hurt the fund’s performance.
For additional information regarding the unique attributes and risks of the fund, see Proxy Portfolio Risk, Premium/Discount Risk, Trading Halt Risk, Authorized Participant Concentration Risk, Tracking Error Risk and Shares of the Fund May Trade at Prices Other Than NAV in the Principal Risks and Proxy Portfolio and Proxy Overlap sections of the prospectus and/or the Statement of Additional Information.
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