ETFs Could Be Salvation for Active Management

When it comes to fund investing, the argument has been framed as active vs. passive, leading to mutual funds vs. index funds and, more recently, mutual funds vs. exchange traded funds (ETFs).

As advisors know, there are plenty of their clients and colleagues that are “dyed in wool” active or passive investors. Advisors and clients are right to enjoy the low fees featured on many ETFs and index funds. Likewise, active management has its perks, particularly in specific corners of financial markets, such as foreign stocks or illiquid bonds.

Still, active management has taken its lumps with criticism accelerating over the past two decades or so – a period including widespread adoption and proliferation of ETFs. However, an interesting scenario is emerging and it bodes well for issuers of active funds: Flows data confirm advisors and investors like active management, but they like it in ETF form. As of the end of the October, there was a combined $444 billion in assets under management across US-traded actively managed ETFs, more than triple dollar amount seen three years earlier.

Translation: ETFs, once viewed as a death knell for active management, may be the management style’s salvation.

Why ETF/Active Combination Matters

The aforementioned flows data is confirmation that advisors and investors like active management. It might also confirm that they don’t like it in mutual fund form or, at the very least, they’re waking up to the benefits associated with the ETF structure.

Those include, broadly speaking , lower expense ratios and reduced capital gains distributions. Let’s be honest. If there’s one thing clients hate, it’s getting a year-end tax bill from an underperforming actively managed mutual fund. The point is ETFs, even those that are actively managed, are more tax-efficient than active mutual funds.

“ETFs are more tax-efficient than mutual funds. Since mutual funds deal in cash, portfolio managers frequently sell securities to generate cash to meet redemptions,” says Morningstar’s Ryan Jackson. “This process breeds trading costs and tax bills that all fundholders absorb—even those who didn’t buy or sell. Meanwhile, ETFs tend to deal in-kind. Just the buyers or sellers bear the related costs—not the fellow investors who stand pat.”

One way of looking at the above is that the ETF structure, which has long been rooted in passive investing, actually lends itself to improving the active experience. However, structure alone doesn’t explain the recent wave of cash into active ETFs and that’s a good thing.

“The ETF structure is central to the rise of active ETFs (more on that later), but they are more than fortunate beneficiaries,” adds Jackson. “Active ETFs represented 3.2% of the ETF market in October 2020 but went on to claim 14% of net flows over the next three years. If active ETFs merely rode the ETF vehicle’s coattails, their market share would not have swelled to 6.3% over those three years.”

Expect More

There are few certainties in investing, but those looking for one might want to note that there certainly be more conversions of active mutual funds into the ETF wrapper. Issuers are seeing the writing on the wall.

After all, it’s hard enough for active managers to beat their benchmarks in the most ideal of circumstances. Throw in high fees and the tax disadvantages and it’s even harder to deliver the goods for investors. So yes, there will be more active ETFs coming to market.

“The ETF Rule and subsequent product-development frenzy started the momentum for active ETFs, and a unique blend of market events and investing trends built on it by bringing their advantages into focus,” concludes Jackson. “Active ETFs are here to stay—the question is how long their dizzying rate of growth can last.”

Related: Important Tax Tips for Retirement Savers