The Five Active ETF Strategies You Need To Know Now

The Five Active ETF Strategies You Need To Know Now
Theodora Lee Joseph, CFA

6 months ago6 mins

  • Actively managed ETFs have surged in popularity this year, since many of their strategies work well in a volatile environment.

  • Active ETFs should never form the core of your portfolio even though they are a good source of diversification.

  • They work best if you have a strong view that you want to execute, so you’ll need to be willing to put in a little more work before investing.

Actively managed ETFs have surged in popularity this year, since many of their strategies work well in a volatile environment.

Active ETFs should never form the core of your portfolio even though they are a good source of diversification.

They work best if you have a strong view that you want to execute, so you’ll need to be willing to put in a little more work before investing.

It’s been a great time for actively managed ETFs. These assets have surged in popularity, making up about 30% of total ETF investments this year. And it’s not too hard to see why: many of them have strategies that work well when markets are volatile, and combine the benefits of both active and passive investing. But there are tons of different active ETFs out there, so let's take a look at five types worth paying attention to now…

1. Long-short stock ETFs

What are they? Buying stocks is easy, but selling (or shorting) them isn’t. Well, not for retail investors anyway. And it is equally tricky to invest in hedge funds that employ such strategies. But long-short stock ETFs offer easy access to such strategies.

These funds aim to outperform the market by buying the stocks that are expected to outperform, and by selling the underperformers. The funds’ managers analyze individual stocks or sectors, and weight their funds accordingly. Most of these ETFs aim to have a market-neutral exposure, meaning returns aren’t likely to be impacted by the market’s swings. Because different funds employ different strategies and fund managers, the performance and characteristics of these ETFs can vary quite a bit.

Who are they for? They’re best suited to investors with a higher risk tolerance and who are looking to outperform the market. But different fund managers take different tactics, so you’ll want to be discerning when picking an ETF.

Examples: AGF US Market Neutral Anti-Beta Fund (ticker: BTAL; expense ratio: 1.54%), First Trust Long/Short Equity ETF (FTLS; 1.36%), and ProShares Large Cap Core Plus (CSM; 0.45%).

2. Event-driven ETFs

What are they? These are “special situation” funds, typically in the domain of private equity, that invest in companies that are facing a significant event, such as a merger, acquisition, bankruptcy, or restructuring. These big changes can create temporary mispricing in the market, and these ETFs try to exploit that. For example, a merger-arbitration fund would place bets between when a deal is announced and when it closes, turning a profit from the gap – or the “spread” – between the target’s share price and its deal price. In other words, they benefit from the transition from uncertainty to certainty.

Who are they for? These funds benefit most when volatility is high, particularly when there’s loads of deal-making. Now, you wouldn’t want these ETFs to form the core of your portfolio, they can help add diversification to your returns, since their performance has a low correlation to the rest of the market.

Examples: IQ Merger Arbitrage ETF (MNA; 0.77%), First Trust Merger Arbitrage ETF (MNRB; 2.23%), and Robinson Alternative Yield Pre-Merger SPAC ETF (SPAX; 0.85%).

3. Leveraged or inverse ETFs

What are they? Rather than simply tracking a market index or asset class, leveraged funds use financial derivatives, such as futures contracts, options, or swaps, to amplify returns. For example, a 2x leveraged ETF aims to deliver double the daily return of its underlying index, while a 3x leveraged ETF seeks to provide triple the daily return. Naturally, declines are also magnified accordingly.

Now those inverse ETFs, also known as short ETFs, do something else entirely: they aim to provide returns that are the opposite of the performance of an underlying index, sector, or asset class. They work best if you have a short-term view on the market’s direction.

Who are they for? Both leveraged and inverse ETFs are much higher risk compared to traditional ETFs. For example, prices only need to fall by a third for a 3x leveraged ETF to lose everything. They suit sophisticated investors with a high risk tolerance and with a very strong short-term view on the market’s direction. If you’re investing for the long term, it may be best to stay away, however tempting the potential returns can seem.

Examples: Xtrackers S&P 500 2x Leveraged Daily UCITS ETF (XS2D; 0.6%), Xtrackers S&P 500 2x Inverse Daily UCITS ETF (XT2D; 0.7%), and WisdomTree EURO STOXX 50 3x Daily Leveraged (3EUL; 0.75%).

4. Options-based ETFs

What are they? Options are contracts that allow you to buy or sell an asset at a specified price on or before the day a contract expires. “Call” options give you the right to buy, while “put” options give you the right to sell, regardless of whether you own the underlying asset. Because options are so versatile, you can pair them with your portfolio to manage your risks by hedging your positions, or generating additional income from selling contracts.

There are a variety of options-based ETFs that serve different purposes. For example, covered call ETFs aim to generate high income with annual yields of up to 13%, but come with a cap on your potential profit if markets appreciate above a certain level. They work best in a sideways market with high volatility.

On the other hand, put-writing ETFs offer you all the upside potential on the underlying asset, but protect you on the downside through the use of protective puts. While put-writing ETFs don’t offer as high a yield compared to covered call ETFs, they work best for risk-averse investors who want protection against deep losses.

Who are they for? If you’re an income investor and don’t mind forgoing the upside potential of markets, you might want to explore covered call ETFs. On the other hand, if you’re risk-averse, and worried about markets tanking, then consider put-writing ETFs because they put a floor under prices.

Examples: Global X S&P 500 Tail Risk ETF (XTR; 0.61%), Global X Nasdaq 100 Risk Managed Income ETF (QRMI; 0.6%), and Global X S&P 500 Covered Call ETF (XYLD; 0.6%).

5. Managed Futures ETFs

What are they? Futures are financial contracts, but unlike options, the buyer or seller of the contract is obligated to buy or sell the asset at a predetermined future date and price. Managed futures ETFs invest in such contracts across a variety of asset classes, including commodities, currencies, fixed income, and stock indexes. These ETFs are often managed using rules-based quantitative models, meaning futures are bought and sold based on algorithms. The strategies used can include trend-following, momentum-based, or mean-reversion approaches, with the goal of generating positive returns regardless of the market’s direction.

Who are they for? If you’re looking for returns that are uncorrelated to the market, managed futures ETFs might help you out, since they typically invest across different asset classes.

Examples: WisdomTree Managed Futures ETF (WTMF; 0.65%), iMGP DBi Managed Futures Strategy ETF (DBMF; 0.85%), and KFA Mount Lucas Managed Futures Index Strategy ETF (KMLN; 0.92%).

What else do you need to know?

Active ETFs are appealing because they’re versatile and give you many more ways to express your investment views. That said, they should never form the core of your portfolio. It’s better to think of them as a complement to an existing set of passive market index ETFs. Since their returns are generally uncorrelated to markets, they’re a good source of diversification. Depending on your risk tolerance, you can start exploring different active ETF strategies. They work best if you have a strong view or preference that you want to execute – so, you first need to understand and test your own hypothesis.

Although expense ratios for such ETFs average about 0.7%, compared to just 0.16% for passive ones, they’re still much cheaper than mutual funds. On the other hand, many of these ETFs don’t have a long trading history and haven’t been tested in extreme volatility. Unlike investing in a passive index ETF, you’ll need to be willing to put in a little more work before investing.



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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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