The strategic advantages of active ETFs in volatile markets

In today’s financial markets, market volatility creates both challenges and opportunities for investors. The challenges lie in anticipating and adapting to erratic price movements. The opportunities stem from those same sudden shifts, which can produce market inefficiencies that skilled investors may be able to exploit, either to reduce risk or to enhance returns.

As we saw in early 2025, equity markets can periodically experience sudden, sharp declines and negative returns. The steeper the drawdown, the larger the subsequent return an investor needs to recover those losses (Figure 1).

This risk can be particularly daunting for investors nearing or entering retirement because it can lock in significant portfolio losses right before they adjust their asset allocation at retirement.

Active ETFs can help investors adapt to both the challenges and opportunities of market volatility. They combine the structural benefits of ETFs—cost‑effectiveness, liquidity, and tax efficiency—with the flexibility of active management.

The ability to buy and sell shares of ETFs on an exchange throughout the day can make it easier for investors to build diversification into their portfolio, compared with buying or selling mutual funds once a day after the market closes.

All about ETFs

Like ordinary mutual funds, ETFs are baskets of pooled securities, such as stocks or bonds, that are jointly owned by the fund’s shareholders. Unlike traditional mutual funds, however, ETFs are listed and traded on the major stock exchanges, which means investors can sell their shares at any time for the prevailing market price instead of asking the fund sponsor to redeem them at the net asset value of the fund’s security holdings.

Like ordinary mutual funds, ETFs can be actively or passively managed. Passive ETFs are generally designed to match the investments in a benchmark index. Portfolio holdings typically are only bought or sold to keep the fund in line with its benchmark index. During market downturns, managers of passively managed ETFs have little or no discretion to make adjustments to seek to avoid losses and limit portfolio volatility.

Managers of active ETFs, on the other hand, seek to enhance returns and/or reduce volatility by adjusting their portfolio holdings based on a predetermined investment strategy. This can allow skilled managers to make quick adjustments in volatile markets, either to seek to mitigate downside risk or to take advantage of temporarily depressed valuations to enhance long‑term returns.

As of August 31, 2025, almost 90% of the nearly USD 12.15 trillion invested in U.S. ETFs was held in passive strategies, according to Morningstar. But ETF Action, an industry data provider, reports that the majority of U.S. ETFs launched over the past few years have offered active strategies. Morningstar’s numbers show that active ETFs now account for more than 10% of total U.S. ETF assets—a share that has more than doubled over the past three years (Figure 2). As a result, investors can now access the benefits of active management within the more liquid ETF structure.

ETFs can provide liquidity in volatile markets

The extreme market volatility that accompanied the onset of the COVID-19 pandemic in March 2020 provides a prime example of how the ETF structure can improve liquidity for investors when underlying markets are illiquid.

Historically, there has been considerable two‑way trading in ETFs on the major exchanges during periods of market volatility. Figure 3, for example, shows how monthly trading volumes in U.S. ETFs spiked during the early stages of the pandemic, at a time when many markets were selling off sharply.

The ability of ETF markets to match buyers and sellers, even in periods of market stress, can make it possible for investors to move in and out of positions relatively quickly during the trading day. In some cases, such as with infrequently traded or non‑listed securities, ETFs may offer better liquidity than is available for the underlying assets that they hold.

Addressing concentration risk

Active ETFs can be vital tools for managing investment uncertainty. We believe that by incorporating multiple approaches to risk management, they can provide more robust performance in fast‑changing markets.

One of the key advantages of having the ability to make real‑time portfolio adjustments is that it potentially can help active ETF managers avoid some of the risks of extreme market concentration—cases where a relatively small number of companies dominate the market capitalization of a particular market sector or benchmark. In such cases, company‑specific setbacks can trigger disproportionate volatility in the sector as a whole.

The U.S. technology sector, for example, has constituted a vital—and exceptionally profitable—part of the global economy and has delivered spectacular returns in recent years. However, many of those gains have been concentrated in a relative handful of mega‑cap stocks, to the point where just three companies—Apple, Microsoft, and NVIDIA—account for more than 40% of market capitalization in the MSCI USA IMI Information Technology 25/50 Index, a benchmark tracked by several major passive tech ETFs (Figure 4).

While most technology‑oriented ETF assets are still tied to the “core” information technology sector—and thus reflect the extreme concentration in that sector—a growing number of active technology ETFs are pursuing more diverse thematic strategies that seek to capture technology‑related opportunities, such as e‑commerce and digital payments, in other market sectors.

The rise of defensive ETFs

One of the fastest‑growing categories of ETFs are those pursuing defensive strategies that use derivative‑based overlays and other risk mitigation tools in an effort to manage equity volatility.

New rules adopted by the Securities Exchange Commission in 2019 opened the door for more derivative usage inside the ETF structure.¹ As a result, a number of ETFs have started to move beyond both passive and traditional active strategies to include strategies aimed at income generation, risk mitigation, and structured market participation. Among these innovative categories are buffered (or defined outcome) ETFs and hedged equity ETFs.

Buffered ETFs seek to offer structured risk mitigation over a predefined period, typically a year. Using options, these ETFs attempt to shield investors from a defined percentage of market losses. However, gains are capped, and if a buffered ETF is not purchased upon inception, the upside cap and downside floor both may not be in line with the original objective.²

• Hedged equity ETFs seek to use dynamic hedging strategies, such as put options or “collars”—positions that include both a put and a call option.³ Unlike buffered ETFs, these hedges often are actively adjusted, offering flexibility in volatile environments.

“...investors can now access the benefits of active management within the highly liquid ETF structure.”

As of December 31, 2024, there were over 400 ETFs available in these two defensive categories, with almost USD 68 billion in assets under management (Figure 5). Although defensive equity ETFs typically are based on a portfolio of stocks passively tied to a particular index, they are considered “active” due to their use of options and other derivative instruments. Buffered and hedged equity ETFs made up approximately 7% of the overall active ETF market.

Advantages and challenges of defensive ETFs

The defined structure of buffered ETFs may be attractive to risk‑averse investors looking for equity exposure with a predetermined downside risk. However, they may offer only limited downside risk mitigation and have some limitations in situations where equity markets first decline and then rally.

Buffered ETFs typically come with a cap on upside potential, limiting returns to the stated objective. Additionally, “long” equity exposure—positions that benefit from rising stock prices—typically is delivered by an index‑based portfolio. Many buffered ETFs also rely on a single hedging instrument, such as S&P 500 Index puts, tied to that same index.

Hedged equity ETFs also are focused on “hedging” or limiting equity exposure in downturns but also offer the potential to participate when markets rally—although this participation typically depends, at least in part, on the specific characteristics of the hedge in place.

Implementation strategies

Since the timing, depth, and duration of every market downturn is unknown ahead of time, choosing the right option strategy can be challenging. This means that buffered ETFs and some hedged equity strategies may not provide as much risk mitigation as investors expect. They also can come with significant costs in the form of explicit expenses and/or a reduction in long-run market return capture.

In our view, a multi‑strategy approach that incorporates multiple elements can deliver more effective downside risk mitigation by providing a robust volatility cushion in a wider variety of drawdown environments.

Given the number of active ETF strategies to choose from, incorporating them in a diversified portfolio requires investors to carefully assess their return objectives and risk tolerances. This is particularly true in the defensive ETF space, where there is a wide range of approaches with varying risk/return profiles. Additionally, investors should carefully read the prospectus of a specific ETF before investing, which outlines risks, objectives and charges, among other information.

Conclusion

By combining the structural features of ETFs—cost‑effectiveness, liquidity, and tax efficiency—with the flexibility of active management, we believe that active ETFs can help investors adapt to both the challenges and opportunities of market volatility.

The flexibility to seek return‑enhancing opportunities potentially can help active ETF managers avoid some of the risks of extreme market concentration. This is particularly important in the critical technology sector, given its heavy weight in the U.S. large‑cap equity market.

Defensive ETFs that incorporate derivative‑based overlays and/or other risk mitigation tools can provide equity exposure with a predetermined downside risk. However, strategies that rely on a single approach—or a limited range of instruments such as broad index options contracts—may not deliver the results investors expect.

We believe that active ETFs that make use of multiple defensive techniques can provide more robust performance in fast‑changing markets.