How to Judge an Active ETF

Actively managed exchange-traded funds are booming. As more investors seek tax advantages, lower costs, and greater flexibility, active ETFs are drawing assets away from mutual funds. Asset managers, sensing the shift, are launching new products or converting old ones, and what was once a trickle of new offerings has become a flood.

However, not all asset managers have mastered the format. Many active ETFs work exactly as promised; others subtly erode returns through poor structure, ill-suited strategies, or high trading costs. Morningstar’s new Guide to Active ETF Due Diligence offers a framework for sorting the worthwhile from the wobbly.

Below is a summary of the guide’s main takeaways.

Some Strategies Fit the ETF Format Better Than Others

An ETF is simply a container for an investment strategy, but unlike a mutual fund, it cannot close its doors to new investors. That means a strategy concentrated in hard-to-trade securities can be forced to take in new money, potentially diluting performance or straining liquidity.

The format works best for portfolios of highly liquid, widely traded securities, or for broadly diversified strategies that can grow without bumping into capacity limits. The simplest way to think about it: The less tradable the underlying assets, the less natural a fit for an ETF.

Investigate the Active ETF Strategy’s Lineage

Some active ETFs are simply new wrappers for old strategies. Others are newly minted, with no history behind them.

That matters, because active ETFs that converted from mutual funds or are near-clones of an existing mutual fund can potentially provide years of portfolio holdings, performance, and manager behavior to scrutinize.

But structural constraints of the ETF format or broader business strategy motivates many asset managers to opt for launching modified versions of an existing strategy. For example, when launching an ETF variant of a preexisting equity fund, asset managers routinely differentiate them from their older siblings by concentrating their portfolios—such as when MFS Active Value ETF held around 60 stocks as of June 2025 versus MFS Value’s 70 stocks, and when Parnassus Value Select ETF held less than 30 stocks versus Parnassus Value Equity’s 45 holdings.

It’s important to understand the differences between the ETF and its older mutual fund (or separately managed account) sibling.

Total Costs Go Beyond the Fee

Most investors check an active ETF’s expense ratio before buying, but that figure tells only part of the cost story. Because ETFs trade like stocks, investors also face the cost of bid-ask spreads—the gap between the price they can buy at and the price they can sell at. An investor who trades often should pay particular attention to the ETF’s spread, which is effectively a small loss on each round-trip trade. A buy-and-hold ETF investor is less exposed to this implicit cost.

Spreads tend to be narrower when the active ETF is popular, when it holds liquid securities, and when market conditions are stable. They widen when the underlying holdings are harder to trade, when the fund lacks much investor interest, or when market volatility surges. Even long-term investors should pay attention to spreads, because persistently wide ones can be a sign of deeper liquidity issues that might affect pricing in turbulent markets.

The full report includes recent data on bid-ask spreads across a wide range of equity and fixed-income Morningstar Categories, offering useful benchmarks to see how a fund stacks up against its peers.

Watch for When an Active ETF’s Price Strays From Its Underlying Value

ETFs trade throughout the day and their market prices can drift from the value of their net asset value. When the price is above NAV, the fund is trading at a premium; when it is below, it trades at a discount. Small, stable differences are normal and not particularly harmful. Large or erratic ones can cost investors money, especially if they repeatedly buy at a premium and sell at a discount.

Funds that hold liquid securities and maintain strong relationships with authorized participants (the institutions that create and redeem ETF shares) tend to keep these deviations in check. Illiquid holdings, low trading activity, or limited AP competition make them harder to control. Stability matters as much as the size of the gap; a steady and small premium is less damaging than one that swings wildly from day to day but averages zero over time.

An Active ETF’s Tax Efficiency Is Not Guaranteed

One of the biggest selling points for ETFs is their tax efficiency. The in-kind creation and redemption process allows them to remove appreciated securities without triggering taxable gains. But not all active ETFs can fully exploit this advantage.

Funds holding assets that cannot be transferred in kind—such as certain derivatives, thinly traded bonds, or shares in restricted foreign markets—may have to sell them for cash, realizing gains in the process. The manager’s capability in using “custom baskets”—tailored sets of securities exchanged with authorized participants during creations or redemptions—to off-load holdings with the largest unrealized gains can also improve tax efficiency.

Checking the fund’s history of capital gains distributions is a practical way to gauge its tax discipline. A clean record, especially from an experienced issuer, is encouraging.

Scrutinize the Quality of the Active ETF’s Issuer

An ETF’s trading quality often depends heavily on its sponsor’s capabilities and relationships. Experienced issuers tend to have stronger trading infrastructure, better support from market makers, and more robust distribution. That can mean tighter spreads, more consistent pricing, and greater investor protection during market stress.

A new or small issuer is not automatically a red flag, but it raises the importance of checking whether they have invested in seed capital, lined up multiple market makers, and have a plan to grow the fund’s assets. Without that support, liquidity can remain poor and the risk of closure higher.

The Bottom Line

Active ETFs can combine professional security selection with the cost, tax, and trading advantages of the ETF structure. But they are not all created equal. The best matches are strategies that are liquid and scalable. Choosing them requires looking beyond expense ratios to understand how the fund trades, how its price behaves relative to its value, how it handles taxes, and how strong its sponsor is.

Done right, investing in an active ETF can give you a nimble, cost-efficient, and tax-savvy building block for your portfolio. Done wrong, it can leave you paying more—in implicit costs and frustration—than you expected.

A previous version of this article was published Aug. 19, 2025.