What Is an Actively Managed ETF? The Front-Running Fear Points at the Wrong Thing

For twenty years the standard objection to putting an active strategy in an ETF was that the wrapper requires you to publish your holdings every day, and publishing your holdings lets other people trade ahead of you. The objection sounded decisive, the industry spent a decade building structures to avoid it, and active ETFs are now everywhere anyway.

The most interesting thing said on Behind the Ticker about this came from a manager who agrees the front-running risk is real and thinks everybody is looking at the wrong source of it. His conclusion is that going active was the defence, not the exposure.

That inversion is the useful way into the whole topic.

What "active" even means now

The definition is genuinely unstable, and the person most entitled to complain about it is somebody running a fund that sits on the line.

Seth Cogswell of Running Oak Capital, asked directly, gave an answer worth quoting at length because the hedging in it is the point. "So the difference between passive and active are the definition I feel like is ever-changing." He went on: "I don’t even know if I know the whatever definition people want to apply these days, but we are defined as active because we use thought."

And then the honest description of his own product: "our strategy is very common sense and thoughtful as far as how it’s constructed, but it’s actually very passive-like as far as the rules-based nature of it," to the point that "you could easily argue that our strategy is index-like."

John Davi of Astoria described his own funds in almost the same terms: "it’s systematic active, not like we’re picking Ford versus GM, it’s all rules based. The actual implementation of it, I would say is active."

So the regulatory label tells you one thing only: whether the fund tracks a third-party index or not. It does not tell you whether a human makes discretionary calls, how concentrated the fund is, or how far it can drift from a benchmark. Those are the things you actually care about, and none of them appear in the word active.

Why they arrived when they did

Active ETFs did not become common because managers changed their minds. A rule changed.

Matt Barry of Touchstone gave the clean version: "once the SEC adopted rule 6c-11, it just made it a lot easier for active managers to come to market," because "instead of filing exemptive relief for each individual strategy, you can rely on that rule."

The second half mattered more than the first. The rule "also allowed tools like custom baskets, tools that are kind of the inner workings of ETFs that weren’t widely available before," so that "now active managers are able to fully utilize tools like that and really level the playing field."

Garrett Stevens of Exchange Traded Concepts confirmed the same shift independently: "Previously, active funds couldn’t use custom baskets the way index funds could. So I think a lot of the tax benefits are a much more level playing field now than they used to be at this point. But four or five years ago, that was not the case."

Custom baskets are what make the in-kind redemption machinery work properly. Before 2019 an active ETF was structurally worse at the thing ETFs are best at. After it, the tax advantage applied to active strategies too, and the wrapper stopped being a compromise.

The transparency argument, from three directions

Here is where the archive is more useful than any explainer, because three practitioners take three genuinely different positions.

The fear was real and managers got over it. The K&L Gates team, describing Ireland, where full daily disclosure has long been mandatory: "managers were quite scared of that initially, I think, and they thought people were going to steal their secret sauce. But I think managers are kind of getting over that now," with large firms now publishing holdings without apparent harm.

Non-disclosure is an underrated feature, for a reason nobody expects. Dodd Kittsley of Davis Advisors, who runs the same strategies in several wrappers, pointed at investor behaviour rather than front-running: mutual funds "don’t disclose holdings. So it allows you the ability to kind of own less liquid securities and for some people, it’s back to emotion," because "some folks don’t have the kind of emotion or wherewithal to see their holdings every single day because it drives them crazy."

That is an argument that daily transparency costs the investor something, by handing them a daily opportunity to react, and it has nothing to do with anyone stealing anything.

The real front-running risk is the index calendar, not the holdings. This is the inversion, and it came from Davi, who spent "18 years on Wall Street trading floor" before running funds.

His concern was not that somebody would see his positions. It was that an index-tracking fund announces its trades in advance by construction. A published index methodology says what gets bought, and the calendar says when. In his words, if the fund got large, "you’d have all these hedge funds out there that would try and game it because they publish an index methodology." You are effectively telling the market "you’re going to trade on the close on the third Friday" of the quarter, and then "all of a sudden you start to lose hundreds of basis points because everyone knows your trade and they’re going to front run you."

His solution was to build the fund as active: "when we rebalance, we don’t have to do it on the third Friday, so that’s why we wanted to make it active."

Read those three together and the picture is much better than the usual one. Daily holdings tell the market what you own, which is a static fact. A published index methodology tells the market what you are about to do, and when. The second is far more exploitable, and it belongs to the passive funds.

What happened to the semi-transparent structures

The industry did build products to avoid daily disclosure, using proxy baskets that approximate the portfolio without revealing it. They exist, and they did not take over.

The team at Exchange Traded Concepts explained why, and it is a distribution problem rather than a design one. There is "a lot of operational nuance to the non-transparent or semi-transparent," and crucially "you have the whole market making community. You have gatekeepers at various wire houses and things who are maybe less inclined to be in favor of the non-transparent. It’s harder for them in a lot of cases, understandably. And so I think that is what has slowed kind of the acceptance."

A market maker who cannot see the basket precisely has to hedge with more uncertainty, which shows up as a wider spread, which makes the fund less attractive to the platforms that would distribute it.

They also named the case where the concern is genuine rather than theoretical: with "a small cap ETF, for instance, it may take a manager days or weeks to work into or out of positions," and in an ETF "people can see it and potentially pick those trades off if it’s not done right."

That is the honest boundary. Daily transparency is close to costless for a large-cap manager who can trade a position in an afternoon, and it is a real problem for a small-cap or thinly-traded strategy that needs weeks.

Two things worth knowing before you buy one

Look at how different it is from the benchmark. Matt Barry stated the prerequisite plainly. Touchstone’s strategies, he said, "will typically look very different from the benchmarks because we believe that to be able to beat the benchmark, a prerequisite is you have to look different from the benchmark." He also named the constraint that catches large managers: "managers that are so big have tens or hundreds of billions of dollars and are by almost definition forced to look a lot like the benchmark."

Since an active ETF publishes its holdings daily, you can check this yourself in about five minutes rather than taking anyone’s word for it, which is transparency working in your favour and is a thing almost nobody actually does.

Dodd Kittsley described what genuine conviction looks like on a holdings screen: "we will never true up, say, a sector that we don’t own. In fact, we don’t own three, four sectors in the S&P 500," because the opportunity was better elsewhere. Whole sectors missing is a meaningful signal. Every sector present at roughly index weight is a different signal.

Keep the base rate in view. Eric Lutton of Sound Income Strategies, himself an active manager, said the quiet part: "adding alpha in equity has gotten very hard over the years. Equity markets are extremely efficient. And that’s why you don’t see too many managers year after year beat the index."

That is not an argument against active management. It is the reason to be specific about what a given manager is doing that the index cannot, and to hold the answer to a higher standard than "we use judgement."

The summary

An actively managed ETF is a fund that does not track a third-party index. That is the entire regulatory meaning, and it covers everything from a discretionary stock picker to a rules-based strategy its own manager calls index-like.

The transparency objection that delayed the category turned out to be smaller than expected for most strategies and real for illiquid ones. The rule change in 2019 mattered more than any of the arguments, because it gave active managers the tax machinery the index funds already had.

What is left is the ordinary question. What is this manager doing that the benchmark does not, how far are they willing to look different in order to do it, and can you see that in the holdings they publish every single day.

This is educational content and not investment advice. It is not a recommendation regarding any security. Investing involves risk, including possible loss of principal. Past performance does not guarantee future results.