Rise of active ETFs: hype, hurdles and road ahead

In Europe, active ETFs have also grown substantially, with inflows reaching EUR 19.1 billion in 2024, up from EUR 6.7 billion in 2023, and accounting for 7.7 % of total ETFs, up from 4.6 % in 2023. Assets in active ETFs grew to EUR 54.4 billion from EUR 29.6 billion in 2023, representing 2.5 % of total ETF assets (according to Morningstar’s review of the European ETF fund market for the fourth quarter of 2024).⁹

Challenges

The active ETF market has meanwhile become as diverse as the UCITS fund market. The span reaches various asset classes and strategies. This includes research enhanced indexing, as well as unconstrained and thematic strategies.

On top of that, active ETFs can also partly reduce the limitations of market-cap indices that are tracked by passive ETFs. Under a market-cap index approach, the biggest companies in an equity index and biggest debt issuers in a bond index have more influence as they constitute a higher percentage in the index. Active ETFs provide the flexibility to tap into entire equity and bond markets, opening up the potential for opportunities to diversify risk and add alpha.

Direct competition with traditional funds

The biggest challenge is that active ETFs are in direct competition with traditional (active) funds. However, Morningstar revealed that active ETFs would not appear to be perfect substitutes for traditional  funds as active strategies typically sold in ETFs do not exhibit the full flexibility of a traditional active fund.¹⁰ Active ETFs must keep tracking error against the benchmark within acceptable levels, which can constrain their ability to fully capitalize on market opportunities. Further, they must contain turnover and management costs, limiting operational flexibility.

The risk of cannibalizing the existing traditional fund range

Nevertheless, active ETFs are becoming increasingly important to investors, a trend that management companies cannot neglect. Yet, while firms look to increase their ETF market share, they cannot ignore the risk of "cannibalizing" their existing active fund ranges. This concern arises from the direct competition posed by active ETFs and the price gap versus the traditional fund range.

The cost conversation

The cannibalism effect becomes more concerning when costs are taken into consideration for actively managed traditional funds. In addition to paying the portfolio manager's salary, the management fee covers the cost of the investment manager's staff, research, technical equipment and travel expenses (e.g., to send analysts to meet corporate management). While fees vary, the average cost for actively managed traditional equity funds is 1.40% (on a one-year basis and excluding subscription and redemption fees).¹¹

According to Morningstar as cited by Fidelity, the average ETF expense ratio in 2024 was 0.48% and 0.69% for index and active ETFs,¹² compared with the average expense ratio of 0.60% for traditional index funds and 0.89% (up to 2%) for actively managed traditional funds.¹³ Expense ratios eat into the returns of funds, so the lower the expense ratio, the better for the investor.

Performance

Looking at aforementioned figures, it becomes clear that the cannibalism fear (active ETF instead of active traditional funds) is justified even more if the active management does not outperform the benchmark. According to research by rating agency Scope, on average only 19.1% of active equity funds across the globe outperformed their benchmark in 2024¹⁴ (down from 23.3% in 2023).^15 16

Turning point

As in other industries that have suffered such competition effects before (e.g., automobiles), there are, as always, opportunities to embrace challenges and channel the competition.

Strategies to avoid direct competition:

• Distinct customers: Market the active ETF to a clientele that is different from their mutual fund counterparts. Slightly alternate strategies can be offered as well as, for example, AI-driven strategies (in contrast to a portfolio manager delivered strategy)
• Other product line: Offer a new ETF with an investment strategy that is different from their current traditional fund strategies. For example, this could be a solely sector-driven bet instead of a “full allocation” bet that would be used on the traditional fund side or an ESG strategy versus a non-ESG approach
• Convert: Convert some of the existing traditional funds into active transparent ETFs
• Competitor consolidation: Explore strategic mergers with and acquisitions of alternatives players to enhance market presence and diversify product offerings 

Offering ETFs 100% cloned from their traditional funds bears the risk that this action may put such ETFs in direct competition with their existing funds and, with a certain likelihood, lead to cannibalization.

Without doubt the cost situation will again be the key aspect in this situation, taking into consideration that portfolio manager and research costs are dominant factors in the equation.

Generally, the anticipated growth of active ETFs will add pressure on the cost-to-income ratio as the trend towards lower fees is unlikely to diminish.

What is the way forward?

For example, in the wealth management or advisory sector with existing clientele (which is actively seeking advice and willing to follow the instruments proposed by the advisor), it can be imagined that traditional actively managed funds will still play an important role for advisors (due to the internal sales scheme and because advice is often not charged separately in certain regions). Flow diversification from different clientele can also benefit investment management companies even if the flows are not for the same fund but are for other portfolios with the same holdings.

Nevertheless, the trend is clearly running in the direction of active ETFs and investment management companies should consider this in their forward-planning. ETFs can be established as an additional offer alongside the traditional fund line; however, it should be clear that the development is expected to increasingly favor lower fees and more transparency, which are advantageous for active ETFs.

If both product lines coexist, it is crucial to establish strategies to mitigate direct competition. Some potential strategies could include:

The examples above show that higher fees can only be achieved by additional services or surplus actions. An interesting prompt may also be a scenario which involves establishing active ETFs for the standard approach of the general investor and using the traditional fund line (with sub-funds) for establishing tailor-made products that fulfill special requirements (e.g., exclusions and other specialties) for investors that have this need and are also willing to pay a surplus charge for such a set-up.

This kind of scenario can also benefit from economies of scale (as the process after the decision can follow the active ETF process). However, the additional costs – in terms of money and time – would be offset by the higher fees, which would represent a fair approach for all participants.

Another aspect is that of tokenization, which is going to take place in liquid listed shares and units. In particular, ETFs will benefit in this scenario for holding, trading and servicing assets. The advantages of blockchain technology include immediate settlement and streamlined transaction flow. The positive outcome is reduced counterparty risk, faster settlement and access to a single trade venue with limited liability risk.

What is Luxembourg doing to leverage the active ETF boom?

Tax – Tax treatment is crucial for ETF adoption, and Luxembourg has made a significant move to attract active ETF issuers by abolishing the subscription tax on active ETFs (since January 2025). This change levels the playing field between passive and active ETFs, removing a cost barrier and enhancing Luxembourg's appeal as a jurisdiction for the launch of ETFs.

Portfolio disclosures – Historically, one barrier to active ETFs has been the requirement for frequent portfolio disclosures. Luxembourg's competent authority has addressed this concern with a practical solution: actively managed UCITS ETFs now need to disclose their holdings (at least) monthly, with a maximum one-month lag.

Streamlined process – A significant advantage is the ability to establish both ETF and non-ETF share classes within the same UCITS compartment. This allows fund managers to introduce an ETF share class within an existing fund structure, leveraging operational synergies and expanding distribution channels without the need for a separate vehicle. Furthermore, Luxembourg allows traditional funds to convert into ETFs, a vital feature for asset managers looking to transition existing strategies into an ETF format.

In closing, as active ETFs gain traction, fund managers must consider the challenges associated with direct competition of traditional funds ranges, as well as the implications for costs and performance. At the same time, fund managers should quickly leverage Luxembourg's favorable conditions to successfully enter and thrive in the active ETF market.

For a detailed look out at our newly launched technical analysis into the accelerating ETF market, read our article How ETF trends are shaping market growth and innovation for 2025.

How EY can help

EY offers a digital fund audit platform, Genesis, for active ETF and liquid funds, developed by our wealth and asset management innovation team. Utilizing the platform, we extract and standardize data from fund administrators, enrich it with market information, and automate validations.

This technology enables auditors to analyze complete datasets, improving accuracy and facilitating the detection of trends and anomalies. With visualizations and online dashboards, clients gain clearer insights, allowing for quicker routine tasks and a focus on high-risk areas. This continuous assurance approach seeks to identify errors quicker, alleviating workload spikes during peak periods.