CONTRIBUTORS
Jason Xavier
Head of EMEA & Asia, ETF Capital Markets
Franklin Templeton
Exchange-traded funds (ETFs) are no longer simply synonymous with passive investing. Over the last 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 the last two years1. With this explosive growth in active ETFs, it’s no wonder that seemingly every conversation I’m having with investors across EMEA, Asia and Latin America revolves around the active segment. They focus on one theme: How active ETFs actually work. Specifically, I continue to field questions about their mechanics. Do they trade? How do market makers price them? And the most common question of all: What happens if a portfolio manager changes positions during the day?
To answer this properly, 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 100.2 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.
In short, the ETF wrapper has matured. Active strategies now sit naturally within it. Once you understand the plumbing, the structure is not only robust, it is elegant.
Endnotes
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Source: Bloomberg, as of January 2026.
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The FTSE 100 Index is a share index representing the 100 largest, most highly capitalized blue-chip companies listed on the London Stock Exchange. Indices are unmanaged and one cannot invest directly in an index. Important data provider notices and terms available at www.franklintempletondatasources.com.
What are the risks?
All investments involve risks, including possible loss of principal.
ETFs trade like stocks, fluctuate in market value and may trade at prices above or below their net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
For actively managed ETFs, the portfolio manager does not attempt to keep the portfolio structure or performance consistent with any designated index, and during times of market rallies the portfolio may not perform as well as other portfolios that seek to outperform an index. Performance of a passive portfolio may vary significantly from the performance of an index, as a result of transaction costs, expenses and other factors.
WF: 9156944