From the engine to the chassis – Jason Xavier, Head of EMEA & Asia, ETF Capital Markets at Franklin Templeton walks us through the mechanics of active ETFs.
Exchange-traded funds (ETFs) are no longer simply synonymous with passive investing. Over the past decade, the ETF wrapper has evolved significantly, and active ETFs are now one of the fastest-growing segments of the market, with assets tripling in just two years.
With this explosive growth in active ETFs, it’s no wonder that nearly every conversation I have with investors across EMEA, Asia and Latin America revolves around the active segment.
They’re all asking the same fundamental questions: How do active ETFs actually work? Specifically they want to understand the mechanics. How do they trade? How do market makers price them? And most commonly:
What happens when a portfolio manager changes positions during the day?
To answer these questions, we need to go beyond labels and look at the mechanics. Let’s lift the bonnet.
The engine: From passive to strategic beta to active
The first generation of ETFs was designed to track broad, capitalisation-weighted passive indices such as the S&P 500 Index or FTSE 100.
These market cap-weighted products provide efficient, low-cost access to diversified portfolios.
While they remain a core building block for many portfolios, their construction can be inherently backward-looking: Companies that have risen the most occupy the largest weights, which may create a momentum bias.
This structural characteristic helped fuel the rise of alternative weighting—or strategic “smart beta” ETFs.
These systematic rules-based approaches adjust portfolio weights based on specific factors such as value, quality or low volatility, rather than pure market capitalisation.
The next evolution was logical. If we can run systematic rules inside an ETF, then why not full discretion? The active ETF was born and has hit the ground running!
Unlike index-tracking vehicles, however, active ETFs do not seek to replicate a benchmark.
They provide portfolio managers with discretion to deviate from index weights and to adjust exposures throughout the trading day as market conditions evolve.
Structurally, however, they are still ETFs. And that distinction is critical since ETFs rely on a key participant.
Masters of the markets – ETF market makers
If you don’t know who these folk are, it’s worth getting acquainted. Once a cottage industry, ETF market makers—from independent specialists to bank desks – have stood strong, supporting the ecosystem across all asset classes with equal robustness.
They’ve done so for nearly three decades and now collectively dominate large sections of publicly traded and over-the-counter secondary markets.
For efficient trading, these market makers need to be able to estimate the ETF’s underlying value in real time so they can hedge risk and quote competitive bid and ask prices.
This applies equally to passive and active ETFs. To do this – and here’s the technical bit – they need to have a chassis portfolio to begin with each day.
This leads us to one of the most misunderstood parts of active ETFs. First, we need to appreciate the chassis.
The chassis: The Portfolio Composition File (PCF)
Every ETF publishes a daily PCF, which market makers receive before the market opens. It’s basically a detailed snapshot of holdings and weights, struck using prior close positions.
It is distributed before trading begins and becomes the official basket used for that day’s creations (subscriptions) and redemptions. You can think of it as an operational blueprint for the primary market.
Crucially, it does not change intraday.
But what happens if the portfolio manager trades intraday? This is one of the most frequently asked questions. If an active manager buys or sells securities at 11:00 a.m., how does the market maker react?
How are prices updated? Does this disrupt bid-ask spreads? In practice, it does not.
Intraday portfolio management and the PCF operate on separate cycles. When a portfolio manager trades during the session, the ETF executes those transactions in the public markets.
The portfolio exposures begin to evolve immediately, and those changes are reflected in the end-of-day net asset value (NAV). The updated holdings then appear in the following day’s PCF.
Throughout the trading session, creations and redemptions continue to reference the morning’s PCF. The settlement basket does not update intraday.
Market makers therefore hedge primarily against the disclosed PCF basket, supplemented by intraday NAV estimates and correlated instruments where appropriate.
The arbitrage mechanism operates on defined baskets and defined timing cycles—not on continuous, real-time synchronisation of underlying holdings.
Why market makers do not chase every intraday change
Market makers are not attempting to replicate every intraday decision made by portfolio managers. Instead, they manage risk relative to the ETF’s traded price, the published PCF basket, intraday NAV estimates and related hedges.
A portfolio adjustment at 11:00 a.m. will influence the closing NAV and be reflected in the following day’s PCF, shaping the next day’s hedge basket. It does not retroactively alter that day’s creation and redemption terms.
This is why the structure remains stable even when the portfolio itself is dynamic.
Built for the grid
Active ETFs operate within the same creation and redemption framework as passive ETFs. The vehicle does not require the portfolio to remain static; it requires clarity and discipline in the operational processes.
The daily PCF provides that anchor, allowing market makers to price efficiently and hedge risk with confidence throughout the trading session.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
Main image: hood, engine, olivie-zemanova-MJDeFIWMnAI-unsplash
