The vast majority of ETFs are passive. They follow a particular stock market index or a particular commodity such as platinum. If an index, including dividends, rises 8% over a year, then a passive ETF tracking that index should rise by roughly 8% too. There's no fund manager picking stocks here.

When ETFs were first launched, all ETFS were passive, but more recently we've seen the arrival of active ETFs where a fund manager makes the final investment decisions.

Just like any investment fund, these active ETFs still have benchmark indices. So if a fund's benchmark is the FTSE 100, that should be your first point of comparison when you evaluate that fund's performance. But crucially a manager of an active ETF can deviate from that benchmark if he wishes. He can avoid a stock or sector just like an active manager of a traditional fund.

Same as Smart Beta?

Active ETFs aren't the same as Smart Beta ETFs. That's because all smart beta ETFs track an index. Granted, not a market-cap weighted index such as the S&P 500 or FTSE 100, but an index nonetheless.

Often a new index is specially created for a new Smart Beta ETF and once that's done, the new ETF does nothing more than track the index. The Smart Beta ETF is following a clear set of rules that were set at inception - there's no opportunity for a human to back his/her judgement and tilt the composition of the ETF.

An active ETF can still stay pretty close to a smart beta index or it can strike out more on its own.

What's the point?

You might think that active ETFs are pretty pointless. If you want to invest in a fund run by an active fund manager, there are countless unit trusts and OEICS out there. And if you want to invest as cheaply and simply as possible, then a passive ETF fits the bill.

But of course, cost and simplicity aren't the only attractions of ETFs. The other big plus point is that ETFs are traded just like shares on a stock exchange. The share price of an ETF changes all the time and you can trade in and out of an ETF several times a day if you wish to do so. With a unit trust or OEIC, you can't do that. The price of the units are set once a day.

That said, in the UK there is another kind of investment fund that is also traded on the stock market like a stock - the investment trust. The first investment trusts were launched in the nineteenth century and they are hugely more popular than active ETFs.

Premiums and discounts

A crucial feature of investment trusts is that they often trade at a 'premium' or 'discount' to the net asset value. The net asset value is the value of the underlying assets that an investment trust owns. The share price is set by supply and demand for the investment trust on the stock market. If the share price is higher than the net asset value, the trust is trading at a premium. If the share price is lower than the net asset value, the trust is trading at a discount.

Conventional unit trusts and OEICs don't trade at discounts or premiums. If someone wants to invest in a particular unit trust, the trust simply creates new units in the trust for the investor. And if someone wants to sell, the units are cancelled. And as we said earlier, the price is set once a day - that price reflects the value of the assets held by the trust. There is no discount or premium.

The crucial point about active ETFs is that they're traded on the stock market, but they don't normally have significant premiums or discounts. That's down to the unique structure of ETFs.

Each ETF has several 'authorised participants' (APs) which are usually investment banks. They a can force the ETF provider to create new shares or redeem them. If a large investor wants a substantial number of shares in an ETF, the investor - perhaps a pension fund - can approach an AP with cash or securities to pay for an ETF purchase. The AP can then hand over some securities to the ETF provider in return for fresh shares in the ETF. The ETF provider is obliged to create new shares if the AP wants them.

Similarly, an AP can hand some ETF shares back to the ETF provider and receive a basket of securities - normally shares held by the ETF - in return.

If a premium or discount appears for the ETF, the AP has an opportunity to make money. If there's a premium, the AP can hand over securities and the provider is obliged to issue more shares. These shares are more valuable than the securities and so the AP is able to make money. As a result of this arbitrage process, the gap between the share price and the NAV quickly narrows.

If the ETF has a discount, the AP can demand to receive securities held by the fund in return for shares in the ETF. This arbitrage process should quickly narrow a discount.

Transparency

If you're wondering why there aren't more active ETFs out there, one big issue is transparency. To work best, ETFs really need to disclose their portfolio daily and many active managers don't like to do this. They're more used to quarterly disclosure which they prefer as it makes it harder for other investors to copy their strategies.

Bonds and equities

Active ETFs are more common in the US than Europe and it's worth noting active bond ETFs have attracted more cash than equity ETFs. That's probably because when it comes to bonds, the case for passive investing isn't as strong as with equities. A passive bond fund will end up buying the most bonds from the most indebted companies or countries, that creates opportunities for active bond managers.

Featured ETF

Vanguard Global Value Factor UCITS ETF (LSE: VVAL)

Vanguard offers four active ETFs in Europe and the Global Value Factor Fund is the biggest of the four with $71 million under management. It's heavily weighted to the US (57% of the fund) and financial services (37% of the fund.) The fund mainly invests in stocks in the FTSE Developed All Cap Index.

The ongoing charge is 0.22% a year. The same charge applies for Vanguard's other three active ETFs in Europe: Vanguard Global Momentum Factor (LSE: VDMO), Vanguard Global Liquidity (LSE:VDLQ) Vanguard Global Minimum Volatility (LSE:VMVL).