Behold the Rise of Active ETFs

One of the obvious phenomenon this year in the exchange traded funds industry is the ascent of actively managed products.

Yes, that rise has been hastened in large part by a significant amount of mutual fund to ETF conversions, but there’s clear momentum for active management in the ETF wrapper and it’s unlikely to dissipate anytime soon. More well-known active mutual fund issuers see the writing on the wall and it says “Advisors and investors prefer ETFs.” Importantly, that’s not a commentary on active management. Rather, it’s an endorsement of the ETF wrapper – one that lends itself to lower fees and superior tax efficiencies. Those are two traits that meaningful to long-term-minded clients.

The rise of active ETFs is important for an array of other reasons, not the least of which the thousands of people retiring every day, boosting demand for ETFs in individual retirement accounts (IRAs), and the great wealth transfer. While baby boomers are increasingly comfortable with ETFs, they’ve long embraced actively managed mutual funds. Plus, heirs, namely Gen X and millennials, that are inheriting those assets have already been devoted fans of ETFs – active and passive.

Advisors, Clients Like Control

One of the big reasons passive ETFs became hits with investors is that market participants enjoy the daily transparency of these products. Most ETFs update holdings on a daily basis, but many active mutual funds only do so monthly or quarterly. Point is, people like control and active ETFs indulge that.

“So knowing what you own, being able to do due diligence, understanding the companies that are in there, the securities that are in there is a big difference. There's also some tax benefits to the ETF wrapper. Some wrappers, at the end of the year, if they have capital gains, they're forced to distribute that,” says Bryon Lake, global head of ETF Solutions at J.P. Morgan Asset Management. “An ETF has some mechanisms which allow it to not avoid the taxes, but give the investor the control of when they'll actually experience those taxes. So there's a number of benefits that make it incredibly convenient to build portfolios using the ETF technology. And ultimately, that gives the investors more control.”

Lake’s point about “ETF technology” is an important because in technological terms, ETFs are far more advanced than actively managed mutual funds. ETFs are more iPhone while active mutual funds are more rotary dial phone. That superior tech is conducive to active management in the ETF wrapper.

“What we've seen now is, distinctly, we have the ETF technology, the wrapper itself with all the conveniences that we talked about, trades throughout the day, tax efficient, transparent, but now we're taking active investment capabilities and delivering those within the ETF wrapper,” adds Lake. There's a lot of benefits to active management. You talk about a lot of those in all the work that you do. I kind of boil it down to three high points, is one, active management gives you the opportunity to outperform. A benchmark can only deliver you the benchmark.”

Active and ETFs: Ideal Match

Index-based ETFs do an admirable job of delivering important goods, such as elevated income and reduced volatility, but those are areas where active management. It’s even better when those advantages with lower fees and tax advantages, as is usually the case with the ETF wrapper.

“So you take the benefits of the ETF wrapper, the benefits of active management and bring those two things together. You pointed it out in the question,” concludes Lake.” So active management had a breakout year in 2022. Going into the year, it was 5% of overall ETF assets. It accounted for north of 20% of the net flows into ETFs last year. And that's continued this year as well, actually. So coming into this year, it was a little more than 5%, just under six. It's accounted for 30% of the net flows into ETFs this year. So investors are really embracing ETFs and particularly embracing active ETFs.”

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