Fund Selectors: “Beyond price and tracking error in ETFs”

Participants:

Q: Do you see active ETFs as a complement to traditional active funds, or more as a tool for cost-efficient alpha in specific areas?

Shakhista Mukhamedova, head of global manager research Europe, RBC Brewin Dolphin: The global manager research team focuses on fund manager selection to provide pre-defined portfolio exposure. Once a manager is chosen, the available investment vehicles are reviewed. Active ETFs can offer cost efficiency — avoiding some regulatory, administration and distribution costs — and ease of trading without cut-off times.
However, ETFs have limitations for active strategies. Alpha dilution risk is higher due to intra-day trading and frequent flows. They are restricted to highly liquid securities, reducing value discovery and alpha potential. Performance can also be affected by premium/discount and bid/offer spreads, which in some cases may offset alpha entirely.

Dan Caps, investment manager at Evelyn Partners: Active ETFs cover a broad range. Most are benchmark-aware “beta-plus” strategies targeting low tracking errors while aiming for modest outperformance. In tough-to-beat markets like the S&P 500 or MSCI World, they offer peace of mind by staying close to index allocations while seeking some alpha, with costs that fall between those of traditional active funds and index ETFs. They work well as core portfolio building blocks, complementing higher-conviction active strategies.
Other launches include covered-call strategies for higher income and buffer ETFs for downside protection. These have specific use cases but can be valuable tools for the right client.

Louis Hutchings, portfolio manager, Nedgroup Investments:  While we don’t invest in active ETFs today, we monitor the space closely as the structure can be compelling in some markets, offering intraday liquidity, cost efficiencies, and transparency. In our active sleeve, we prioritise boutique managers with aligned incentives, strong research, and proven specialist access. What matters most is not the wrapper, but repeatable alpha, clear process, and long-term partnerships.

Adam Gage, multi-asset portfolio manager and fund selector, BNPP AM: Our focus is less on the product wrapper and more on the underlying strategy. We use both mutual funds and ETFs, valuing the distinct benefits each brings. Many recent active ETF launches fall into the low-tracking-error or ‘enhanced passive’ space, often with attractive cost structures. These offer more flexibility than pure index trackers, helping manage transaction costs, ESG constraints, and today’s index concentration issues. Looking ahead to a more volatile landscape, delegating more risk to light-touch active managers helps rebalance the heavy tilt toward pure beta seen in recent years.

Victoria Hasler, head of fund research, Hargreaves Lansdown: We do not currently research active ETFs as we have simply not seen enough demand from clients. The use of ETFs by our client base is growing rapidly, but the majority is still in passive ETFs rather than active ones.

Fund selectors: We “can’t afford to ignore” active ETFs

Q:  Given the rise of model portfolios and outsourced CIO solutions, how do you differentiate between ETF providers beyond price and tracking error?

Shakhista Mukhamedova: In addition to qualitative and quantitative assessment, we undertake analysis of parent companies’ stewardship policies. We view stewardship as an additional tool available to passive fund managers to minimise risk. Quality stewardship practices involve in-depth research of investee companies’ risks related to ESG and engaging with the company management to flag these. We have seen a few fund managers with strong stewardship frameworks successfully identifying these risks and managing them more efficiently.

Dan Caps: For index-tracking ETFs, price and tracking error matter, but we look further. First, examine the index tracked: country weights vary across global/regional indices, and thematic methodologies differ sharply. For two ETFs on the same index, review the securities-lending program, whether it’s used, the revenue share to investors, the proportion on loan at any time, and the collateral held to mitigate counterparty risk. Structure can be crucial: an S&P 500 ETF domiciled in Luxembourg faces 30% dividend withholding tax vs 15% for an Irish one; swap-based exposure can deliver the gross index return with no dividend WHT, minus a small swap fee. We also consider listing venue, trading currencies, issuer, trade volumes and dealing spreads as part of due diligence and onboarding.

Louis Hutchings:  Beyond price and tracking error, we emphasise the overall robustness of the ETF provider, from index construction quality, rebalancing and replication approach to client servicing. We also weigh governance standards, securities lending, and ESG engagement. Scale and cross-market experience are key for access, liquidity, and resilience in stressed markets. Ultimately, it’s about trust, transparency, and consistency, not just headline cost.

Adam Gage: Beyond price and tracking error, we value building genuine partnerships with ETF providers. Two-way communication is key, and our experience with active managers shows dialogue works best when providers understand our processes, needs, and challenges. This collaboration keeps both sides aligned on product, index, and market changes, and can even spark new tailored solutions. In specialised asset classes, providers stand out through high quality education, research, and insights that strengthen our cases. Those who deliver expertise and support beyond the product itself become trusted partners, gain more engagement, and often attract greater allocations.

Victoria Hasler: While ETFs are not currently on our curated selection of funds that the research team believes have the strongest long-term performance potential, for those under research coverage, we assess providers as we would any fund — examining replication strategies, team quality, dealing and risk functions, business strength and compliance. In a highly competitive market, taking a holistic view ensures we secure the best outcomes for clients.

“Process over preference”: Fund selectors reveal what delivers

Q:  With all the focus on transparency and data today, how closely are you looking at the behind-the-scenes infrastructure of ETF issuers, such as their trading support and resilience?

Shakhista Mukhamedova: The financial strength of a fund provider is a standard part of our due diligence process. We also review how they support their trading, the number of market makers and APs they work with, and the parent track record. For example, frequent product launches followed by closures due to poor performance or insufficient assets would be a red flag. Post-sales service and support are also important factors for us.

Dan Caps: This is an increasing focus for us. While we assess each issuer individually, we also monitor the broader ETF ecosystem. This year will set a new global record for ETF launches, surpassing last year, with most being active ETFs and many incorporating derivative exposure.
With more ETFs and rising complexity, we’re evaluating the capacity of authorised participants and market makers to handle higher demand and a shifting landscape. Encouragingly, significant system investments are improving efficiency, but we will closely watch this space as these trends in ETF launches are likely to persist.

Louis Hutchings:  We view the operational infrastructure of ETF issuers as a fundamental part of their value proposition and not merely a back-office function. Every provider undergoes a rigorous, independent operational due diligence process before investment. This includes a detailed assessment of trading support, risk controls and overall resilience. These elements, while less visible than fees or tracking error, are critical to ensuring ETFs function as expected, especially in volatile markets. They play a central role in shaping our broader view of provider quality and reliability.

Adam Gage: We conduct rigorous operational due diligence on ETF issuers, paying close attention to trading support and infrastructure resilience. This independent process validates that we are selecting providers with strong compliance and robust operations. Equally important are our own dealing capabilities, infrastructure, and broker and authorised participant relationships, which ensure seamless trade lifecycle support. We also track shifts in the trading ecosystem, such as the rise of portfolio trading, efficiencies from RFQ venues, and automation of PCF processes. Providers who offer additional transparency or trading insights are particularly valued, as they strengthen our understanding and execution.

Victoria Hasler:  These aspects matter greatly to us. With clients typically investing for the long term, we must ensure the funds we recommend remain fit for purpose for years to come.