by Michael Johnston on June 6, 2011 | Updated September 11, 2014

As active ETFs have burst on to the scene, a number of investors have expressed confusion over certain aspects of these vehicles. While active ETFs are relatively simple and straightforward, there are questions surrounding some of the more nuanced elements of the active ETF structure:

Q: What is front-running? Is it a concern for active ETF investors?

A: Front running refers to the practice of establishing or exiting a position based on anticipated movements of a large buyer or seller in a security in order to generate a profit. If an individual or institution has information that a major fund is bullish on a particular stock and looking to establish a sizable position, that investor can front run the fund by purchasing shares. If the fund does indeed begin to buy a significant number of shares, the price should rise as demand increases. Obviously, executing a front-running transaction requires knowledge (or at least suspicion) of the intentions of another larger player in the space. And there are ways to front run that are 100% legal.

Front-running is relevant when it comes to active ETFs because of the disclosure requirements imposed on these securities. While mutual funds are required only to disclose their holdings once per quarter, ETFs post holdings to their web sites on a daily basis. So if it takes an actively-managed ETF multiple days to establish or liquidate a position, the changes in daily holdingswhich are available to anyone with an Internet connectioncan tip off the managers strategy and future intentions.

Suppose that a sample active ETF (ABC) is bullish on Zion Oil & Gas (ZN), a small energy company with a market cap of about $140 million. The manager wants to establish a position of about 1,000,000 sharesabout six times the average daily volume. In order to avoid moving the market, the trade must be executed over several days. So someone watching ABCs nightly portfolios might notice that the position in ZN goes from zero to 200,000 shares to 400,000 shares over the course of a couple days. If they suspect that the buying will continue, they may jump into ZN in anticipation of further buying putting upward pressure on prices. If enough front-runners identify ABCs intentions and jump into the fund, the pool of buyers will increase and it will become more challenging for the manager to establish the desired position at the optimal price.

Front runningor the threat thereofis often cited as a reason for the relatively slow growth of the active ETF space, but in reality this phenomenon doesnt pose a significant risk. In most instances, managers will be able to execute a trade within a single trading day, meaning that by the time a shift in holdings has been disclosed the front running opportunity has passed. Moreover, managers looking to establish a sizable position in a security that may be less liquid than large cap U.S. stocks have a number of tools available to them beyond simply executing a trade on the open market. There are various sources of alternative liquidity out there that can be used to avoid creating an opportunity for any front running.

It should also be noted that there is some confusion over exactly what is required in terms of ETF disclosure. ETFs are required to publish their creation basket daily, but only has to release full holdings on a quarterly basis. That affords additional flexibility in creating a lag on holdings disclosure [more on this topic in a nice piece here ].

In reality, front running may be more of a concern in index-based bond ETFs that exhibit predictable trading patterns in order to comply with maturity guidelines [see Bond ETF Breakdowns: Case For Active Management In Fixed Income Arena ].

Q: What makes an ETF active?

A: At one end of the active/passive spectrum are ETFs linked to cap-weighted benchmarks that simply seek to own the market. At the other end are funds run by a team of managers that have complete discretion over which securities are bought and sold and the timing of such transactions. But there is a lot of gray area in between, especially as innovation in the ETF industry has resulted in a number of products that blur the line between active and passive. A few examples of such ETFs include:

• Enhanced / Intelligent Indexing: There are dozens of ETFs that seek to replicate enhanced or intelligent benchmarks that utilize quant-based strategies to construct a portfolio designed to outperform traditional cap-weighted indexes. So while the indexes attempt to generate alpha by utilizing proprietary analytical techniques, the ETFs that seek to replicate these benchmarks are passive in that they are clearly linked to a predetermined index.

• Alternative Weighting:  A number of ETFs have popped up that seek to replicate indexes that use unique weighting methodologies; RevenueShares offers a suite of revenue-weighted ETFs, Rydex and State Street have pioneered equal weighting, and PowerShares has made a big push into the RAFI ETF space. While alternative-weighting ETFs are passive in that they seek to replicate an index, the related benchmarks are arguably using rules-based methodologies to implement types of active management. Earnings-weighted ETFs focus on low P/E stocks, while revenue-weighted funds effectively buy based on price-to-sales multiples.

• Sampling Strategies: While some ETFs fully replicate the index to which they are linked, others employ a sampling strategy that involves purchasing a sub-set of the total benchmark that will generally maintain similar risk/return characteristics. For example, AGG owns only a portion of the bonds in the Barclays Capital U.S. Aggregate Bond Index, and the portfolio managers are responsible for constructing a basket of stocks that will closely replicate the performance of a much broader hypothetical index.

Strictly speaking, an active ETF is one that does not seek to replicate a specified index. So the AlphaDEX suite from First Trust and Intellidex products from PowerShares would qualify as passive ETFs since they seek to replicate an indexeven though the index has the goal of generating alpha relative to cap-weighted benchmarks.

Q: How do active ETF expenses compare to mutual funds? To passive ETF expenses?

A: ETFs have become popular thanks to a number of structural advantages, including improved tax efficiency, intraday liquidity, and better transparency. But a big reason behind the ETF boom relates to fees; indexing strategies allow for the elimination of many of the expenses required in running a traditional active mutual fund. There is no need for a team of analysts or advanced research tools; replicating an index is a relatively straightforward task.

Active ETFs are generally more expensive than passive ETFs, since the overhead and expenses required to run an active ETF are greater (portfolio managers dont work for free, and research expenses can be significant). But active ETFs can still offer substantial savings over active mutual funds, thanks in part to the elimination of certain administrative functions through the use of the exchange-traded structure.

When an investor buys or sells shares of a mutual fund, the fund company is a counterparty to the trade, either taking cash and handing over shares of the fund or distributing cash in exchange for shares. Each transaction requires record-keeping, commissions, and other costs in order to ensure orderly entrances and exits. ETFs, on the other hand, trade like stocks. The vast majority of transactions do not involve the ETF issuer in any way; they take place between two market participants, often anonymously. While some overhead is required of active ETFscreation and redemptions require administration, and there are a number of other functions that cant be automatedthe scale is considerably smaller than in the mutual fund world.

In short, active ETFs are generally more expensive than passive ETFs but are often considerably cheaper than comparable mutual funds thanks to the efficiencies of the exchange-traded structure. As of September 11, 2014, the average expense ratio for active ETFs was only slightly higher than the comparable metric for passive ETFs: