Why the evolution of ETFs is changing the due diligence equation

Exchange-traded funds (ETFs) have moved well beyond their original role as low-cost, passive building blocks. Total assets in ETFs have grown rapidly over the past five years, rising at a 20 percent compound annual growth rate.¹

This evolution has expanded the toolkit available to advisors. Today’s ETF universe includes more complex exposures, differentiated portfolio construction approaches, and varying levels of transparency. All of which raises the due diligence stakes, as evaluation now requires more than a glance at expense ratios and index names.

For advisors, the question is no longer whether ETFs belong in portfolios, but which ones. How do we identify which structures and strategies truly support client outcomes in a more volatile and fee-conscious environment?

A market once dominated by passive index ETFs has begun to shift, as new entrants have gained ground. As a result, ETF investors – long accustomed to mostly low-cost, straightforward index exposure – now need to conduct more thorough due diligence. 

How active and factor-based ETFs are expanding advisor choice

Many of the benefits of lower costs and tax efficiency now extend to active and factor-based ETFs, which offer more targeted exposures within an efficient structure. This raises new questions about how ETFs should be evaluated. As active strategies move into ETFs, evaluating value requires looking beyond just the expense ratio of the fund.

ETFs were once primarily used for low-cost exposure to broad markets, a role they still play for the largest S&P 500-tracking funds. Today, however, many advisors are looking beyond the S&P 500 due to concerns about valuations, market concentrations, earnings expectations, or other factors. The proliferation in ETFs now allows advisors to retain tax advantages in nonqualified accounts while accessing a wider range of investments.

Understanding What an ETF Really Holds

Even with passive funds, it’s important to know whether a fund will be consistent in its asset class and investment style over time. A few subtle differences could lead to significant changes – not only in performance, but also in how a fund correlates with other funds in your portfolio. Take these examples:     

• An S&P 500 fund and an equally weighted S&P 500 fund may track the same index, but they allocate capital very differently – especially to the largest companies – resulting in distinct performance patterns. 
• Recently popular options-based ETFs – specifically defined outcome and derivative income funds – may have drastically different market exposure at any given point, depending on how each fund structures its options. 

Applying active management due diligence to active ETFs

Traditional active management due diligence applies just as directly to active ETFs.  Understanding the portfolio team, investment philosophy, and decision-making process is critical to understanding how the fund may perform in different market conditions and how it fits within a broader portfolio. 

Following the ETF Rule of 2019, many fund sponsors accelerated active ETF launches. Some of these ETFs closely resemble existing mutual fund strategies, while others reflect meaningful structural differences, such as higher concentration or portfolio adjustments for distribution and advisor compliance needs.

When evaluating ETFs – particularly those with shorter track records – analysis should extend to the management team and the records of their mutual funds. A clear understanding of how a manager drives returns can help advisors maintain conviction during short-term periods of underperformance that align with the strategy’s style. 

Tax, transparency, and trading considerations

While ETFs are generally more tax-efficient than mutual funds, they’re not immune to capital gains distributions. This may surprise clients and advisors accustomed to passive products that have low turnover and minimal distributions. Higher portfolio turnover or elevated redemptions that cannot be fully managed through in-kind distributions could lead to some capital gains distributions. 

Another important distinction is that ETFs cannot be closed to new investors, which is particularly relevant in smaller asset classes where asset growth can influence portfolio construction and performance. While some fund sponsors hesitate to launch products in areas like small caps, advisors should monitor existing ETFs as they scale to ensure they  remain true to their stated style and process. 

Transparency and trading dynamics also vary across ETFs, as active managers can choose between fully transparent, semi-transparent, and non-transparent structures. Less transparency may help protect intellectual property but may also lead to wider premiums or discounts relative to underlying holdings.

Although expense ratios are often lower, higher trading costs – such as wide bid-ask spreads – can offset those savings, especially for frequent traders. 

What the continued evolution of ETFs means for advisors

The rapid growth of the ETF market has expanded choice, flexibility, and access, but it has also raised the bar for due diligence. As more active and specialized strategies adopt ETF wrappers, cost and structure alone are no longer sufficient to assess value.

The advisors best positioned to benefit will look deeper – assessing portfolio construction, management discipline, trading dynamics, and overall portfolio fit. In a landscape defined by innovation, thoughtful implementation – not product proliferation – will ultimately drive better outcomes.

Rob Swanke is a senior investment research analyst on the Equity Research team at Commonwealth.

1. J.P. Morgan Asset Management: Guide to ETFs. 2Q 2026. As of March 31, 2026.

This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. These views are subject to change at any time. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict.