Here’s What Investors Should Know as Actively Managed ETFs Take Off

After decades of being dominated by index-tracking investments, the ETF market is being flooded by actively managed funds. In 2013, a mere 16% of newly launched ETFs were actively managed, according to Morningstar. That jumped to 66% in the first quarter of this year, following three straight calendar years of more than 50% of new ETFs being active.

Actively managed ETFs are a way for investors to get the tax efficiency of ETFs and the ease of trading them, but still rely on fund managers’ discretion in portfolio allocations, instead of buying an ETF that tracks a preset selection of assets.

That is, if they want to rely on fund managers’ discretion. There’s plenty of evidence that managed investments, including mutual funds, don’t beat their benchmarks consistently.

“If you believe in active management—that stock picking and bond selection can add value—then active ETFs are a great alternative to mutual funds," says Todd Rosenbluth, head of research at research company VettaFi. For those who are in that camp, however, there are some key things to consider, both in comparing ETFs with mutual funds, as well as comparing active ETFs with passive ETFs.

Returns, taxes and fees

Part of the ETF advantage over mutual funds is that ETF managers can remain fully invested at all times if they choose, and so aren’t forced to make investment decisions that can dent their funds’ returns. That’s because when an investor sells shares in an ETF, the shares go to another investor—they’re not redeemed by the fund the way mutual-fund shares are. Mutual-fund managers keep some cash uninvested to provide for fund redemptions, and sometimes they need to sell some of their holdings to cover redemptions. In both cases, the mutual fund’s performance can take a hit.

Also, ETFs offer a tax advantage over mutual funds. For mutual-fund holders, gains are taxable whenever the fund manager sells a security at a profit. For ETF holders, gains are taxed only when the ETF is sold. So an ETF investor can put off any capital-gains taxation.

And while fees for actively managed funds of all kinds generally are higher than those for passive funds, there’s a cost difference between actively managed mutual funds and active ETFs. Actively managed ETFs have weighted average annual expenses of 0.44% of assets compared with 0.57% for active mutual funds, according to Morningstar. That’s more money in ETF investors’ pockets.

The downside

Experts say there is more potential in certain kinds of actively managed ETFs than others. For instance, they are especially wary of ETFs that focus on large-cap stocks such as Exxon Mobil, Apple, Google parent Alphabet, Netflix and similar-size companies in the S&P 500.

There’s little advantage to active management in those cases, says Robert Stammers, former director of investor engagement at the CFA Institute, because so many investors follow such stocks so closely that it’s hard to get ahead of the market on their movement.

However, less-watched sectors provide greater potential for active managers. Stammers points to real-estate investment trusts, commodities, private credit and private equity as examples of sectors where active management can be better than indexing. “It needs to be off the beaten track, where the manager can add value," he says.

One approach is to build a portfolio that mostly holds index ETFs but also includes some actively managed ETFs in sectors that the investor thinks are ripe for gains that a fund manager might be able to maximize, says Vincent Catalano, chief markets strategist at Stuyvesant Capital Management in New York.

Such a hybrid approach can be attractive to investors who want to actively trade but still avoid underperforming the market, Catalano says. These investors get the thrill of trying to beat the market but retain a cushion in case the bets don’t pay off.

Simon Constable is a writer in the Occitanie region of France. He can be reached at reports@wsj.com.