How to Evaluate an Active ETF Beyond the Expense Ratio

The Expense Ratio Obsession

Somewhere along the way, the financial industry decided that the most important thing about an ETF is how much it costs. Expense ratio comparisons dominate every article, every screener, every advisor conversation. And look, fees matter. I’m not arguing otherwise. But the laser focus on expense ratios has created a generation of advisors who can tell you the cost of an ETF to the basis point but can’t tell you how the portfolio actually gets constructed.

That’s a problem. Because when you’re evaluating an active ETF, the expense ratio is maybe the fifth most important thing you should be looking at. Maybe sixth. The process, the consistency, the risk management framework, the track record versus the model, the structural incentives of the manager — all of these matter more than whether the fund charges 50 basis points or 65 basis points.

A bad strategy at 15 basis points is still a bad strategy. A great strategy at 75 basis points can still be the best holding in your client’s portfolio. Let’s talk about what actually matters.

Start with Process, Not Performance

The single most important question you can ask about any active ETF is: What is the investment process, and is it repeatable?

Performance numbers tell you what happened. Process tells you why it happened and whether it’s likely to happen again. A fund that returned 20% last year because the manager made three great stock picks is a very different animal from a fund that returned 20% because a systematic, rules-based process identified and captured a specific market inefficiency. The first one might not be repeatable. The second one probably is.

When you’re evaluating process, here’s what to dig into:

• Is the process clearly defined and documented? Can the manager explain exactly how portfolio decisions are made, from signal generation to position sizing to rebalancing? If the answer is vague or hand-wavy — “we look at a lot of factors and use our experience” — that’s a yellow flag. A repeatable process should be describable in specific terms.
• Is the process systematic or discretionary? Neither is inherently better, but you need to know which one you’re buying. Systematic processes follow defined rules that can be backtested and stress-tested. Discretionary processes rely on human judgment, which introduces both the possibility of exceptional insight and the certainty of behavioral bias. Most strategies fall somewhere on a spectrum between the two.
• How does the process adapt to different market environments? A process that works beautifully in trending markets but falls apart in choppy, range-bound environments has a limitation you need to understand. Ask the manager: when does your process struggle? If they say “never,” walk away. Every process has environments where it underperforms. Honest managers know what those environments are and can articulate them clearly.

Track Record vs. Live Performance vs. Model Portfolios

This is where a lot of advisors get tripped up, and it’s where a lot of fund companies take advantage of the confusion.

Backtested performance is what the strategy would have done historically, based on current rules applied to historical data. It’s inherently biased — the person designing the backtest knows how the story ends. The bad backtests never make it into the marketing deck.

Model portfolio performance is a step up. Real-time signals generated and recorded, but not necessarily traded with real money. It removes look-ahead bias but doesn’t account for execution costs, slippage, or market impact.

Live fund performance is the gold standard. Real money, real trades, real costs. The gap between model and live performance can be surprisingly large.

When evaluating an active ETF, here’s the framework:

• If the fund has less than three years of live track record, treat the performance data with caution. It could easily be driven by luck or a favorable environment rather than genuine skill.
• Ask to see both the backtested and live performance, and compare them. If the backtest shows 15% annual returns and the live fund has delivered 8%, that gap needs a compelling explanation.
• Ask what changed between the model and the live fund. Were parameters adjusted? Were rules modified? Transparency here is a strong signal of trustworthiness.

Risk Management: The Under-Examined Factor

Most advisors evaluate active ETFs primarily on return. But the risk management framework is where active ETFs differentiate themselves most significantly, and it’s the dimension most advisors spend the least time evaluating.

Questions worth asking:

• What is the maximum drawdown the strategy is designed to limit? The manager should be able to articulate how the process handles adverse conditions. “We stay fully invested and ride it out” is very different from “our process systematically reduces exposure when risk signals deteriorate.”
• Can the strategy hold cash or cash equivalents? A fund that can move to 50% cash in a crisis will behave very differently from one that’s mandated to stay fully invested.
• What happened during the 2020 COVID crash and the 2022 bear market? If the fund was live during both, look at the actual drawdown numbers. If it wasn’t live, ask the manager to walk through what the model would have done.
• How does the fund handle correlated risk? Does the process have explicit limits on sector, factor, or single-name concentration?

Red Flags to Watch For

After years of talking to fund managers and evaluating strategies, certain patterns reliably indicate problems. Here are the red flags that should make you ask harder questions:

• Backtest-only track record with no explanation of parameter selection. If someone shows you a beautiful backtest but can’t explain why they chose those specific parameters, they probably optimized it to look good. A strong strategy performs well across a range of parameter values. A curve-fit strategy falls apart when you tweak anything.
• “We’ve never had a losing year.” This is either a very short track record or a strategy that will eventually blow up. Every legitimate strategy has losing periods.
• Complexity for complexity’s sake. If you can’t understand how a strategy works after a 30-minute conversation with the manager, that’s a problem. You can’t evaluate what you can’t understand, and you can’t explain to clients what you can’t evaluate.
• Asset-gathering language over performance language. If the manager spends more time talking about marketing and distribution than their investment process, your priorities are different.
• No skin in the game. Does the portfolio manager invest their own money in the fund? This is disclosed in regulatory filings and it’s one of the strongest signals of conviction.

The Due Diligence Checklist

A practical framework for evaluating any active ETF:

• Process: Can you explain how the fund makes decisions in two sentences? If not, dig deeper or pass.
• Consistency: Does the fund do what it says? Do the stated objective, actual portfolio, and performance all match?
• Risk management: What is the worst-case scenario, and how does the process address it?
• Track record integrity: How much is live versus backtested? What’s the gap?
• Structural alignment: Does the manager invest alongside you? Are incentives aligned with long-term performance?
• Expense ratio: Yes, it matters. But it’s last on this list for a reason.

The Bottom Line

Active ETFs are the fastest-growing segment of the ETF market. That growth means more choices for advisors, which is good. It also means more noise, more marketing, and more products that look better in the pitch deck than in the portfolio. The advisors who do the best work for their clients are the ones who look past the expense ratio and evaluate what actually drives outcomes: process, risk management, consistency, and alignment. Those are the things that matter. Everything else is a rounding error.