Are Active ETFs a Lifeline for Active Managers?

Exchange-traded funds used to be synonymous with passive investing. But as outflows drain from active mutual funds, some asset managers have turned to ETFs for salvation.

Active mutual funds claimed more than $13 trillion in assets at 2023’s end, nearly 25 times more than their ETF peers. But they continue to log outflows year after year. Meanwhile, the active ETF market recorded a 37% average organic growth rate in the last decade and shows no signs of slowing.

A few active ETFs have racked up assets under management, yet many of the 320 providers have struggled. Assets have mostly funneled to a few issuers who dominate the market.

So what do successful active ETFs have in common? And where do asset managers go wrong?

Morningstar covers more than 25,000 exchange-traded funds worldwide. Here, we break down the research on active ETF flows and performance.

Actively managed ETFs could unlock growth for asset managers if they can capture more of the active management market.

The ETF wrapper comes with benefits for active investment strategies.

• Tax efficiency. Mutual funds must buy or sell holdings to cover inflows or redemptions. ETF managers can exchange shares for underlying holdings, and vice versa, without creating a taxable event.
• Low expense ratios. Active ETFs don’t have sales loads or 12b-1 fees. Their average fee (0.65%) is 36% cheaper than that of the average active mutual fund.
• Flexible trading. Investors can buy or sell active ETFs throughout the trading day. They also can go long, sell short, buy on margin, trade options, and lend to others for a fee.

But active ETFs also come with drawbacks.

• Capacity risks. ETFs can’t close to new investors when they get too big. When a fund reaches capacity, it can slip into mediocrity or start altering its strategy.
• Higher trading costs. Since ETFs trade like stocks, they also have bid-ask spreads. Niche ETFs can have wide spreads, especially near the opening and closing of the trading day.

Asset managers can bring active ETFs to market with a few different approaches.

Most active ETF strategies are unique and represent new approaches to beating benchmarks. The benefits of ETFs make developing and launching a new strategy easy.

However, strategy development may take longer than alternatives, and firms might need new resources to run the ETF. The biggest downside is having to build the ETF’s track record and asset base from scratch.

Managers run these ETFs in tandem with established mutual funds. This approach keeps mutual fund investors and distributors happy while tapping a new market. The ETF can use the same portfolio managers and track record as the mutual fund for instant credibility.

The biggest tradeoff?

Online brokerages could boot the pricier mutual fund share classes. Nontransparent ETF also can't invest in foreign holdings or private companies. That can create performance disparities between clones and their mutual fund siblings.

With conversions, issuers inherit the mutual funds’ track record and asset base. But so far, only Dimensional has found meaningful success with this tactic.

Despite interest from fund providers, the conversion process can be difficult. Converted funds must still have merit and competitive fees. Issuers must also have the resources and network to support them.

Some plan sponsors can’t support ETFs on their platforms, making a conversion all but impossible for many funds. And if firms use 12b-1 fees to pay for marketing, the conversion would cut off established distribution networks.

As of May 15, 2024, 12 firms have sought exemptive relief from the SEC to offer active ETF share classes.

If regulators approve, firms can expand access to strategies while sidestepping operational challenges. Firms wouldn’t have to worry about retirement plan assets, disrupted distribution networks, or creating new investment strategies.

ETFs also boost the tax efficiency of the mutual fund share classes. In turn, the ETFs benefit from the mutual funds’ track record and assets.

There’s one potential downside. Early on, ETF investors could face distributions from preexisting capital gains and sharing of portfolio costs.

In 2016, the SEC approved the first nontransparent ETFs. The wrapper shields an ETF’s holdings while giving market makers enough information to accurately price shares.

However, these types of funds have yet to take off. The structures created confusion for advisors and investors alike.

Early adopters of nontransparent ETFs, like Fidelity and T. Rowe Price, have shifted gears. Each introduced a handful of fully transparent ETFs in 2023.

Morningstar covers performance, holdings, ownership, and operational data on exchange-traded funds.

Here’s what successful active ETF approaches have in common.

Funds in the cheapest quintile of active ETFs hold more than $325 billion in assets, while those in the most expensive quintile hold $35 billion.

Liquid or frequently traded holdings, like large-cap stocks, work best in the ETF wrapper. That’s why active stock ETFs in large-cap categories hold the most assets.

Unfortunately, it’s tough for active managers to beat passive ones in the large-cap US stock market.

Although capacity can be an issue, fixed-income ETFs rarely have to close to new investors because of the breadth and depth of the bond market. ETFs can serve as an efficient secondary market to provide liquidity when underlying bonds aren’t trading.

Over-the-counter trading can leave bonds susceptible to periods of low liquidity. High-yield bonds, bank loans, and complex asset classes, such as structured credit, can be less liquid.

Bond ETF bid-ask spreads may widen in volatile market conditions, increasing trading costs. But they still may have lower trading costs than those of the underlying bonds.

Well-diversified portfolios can forestall capacity problems.

Firms have found success in less-liquid markets by starting with a broad portfolio as their target market. Then managers tilt toward stocks with certain characteristics, like low valuations. This often results in portfolios that spread their assets over hundreds or even thousands of stocks, limiting their capacity risk.

One capacity-constrained market is emerging markets, where stocks tend to be less liquid than those in developed markets. Emerging-markets ETFs can have wider spreads, so active strategies in this group need to be well-diversified to work as ETFs.

Most ETF clones cost about the same as the institutional shares of the mutual funds. The former has other cost advantages over the latter, though. The ETFs usually distribute fewer capital gains than their mutual fund twins.

Mutual funds also typically hold more cash than ETFs to meet redemptions. Dimensional’s and Avantis’ ETF clones often hold less than one-fifth of the cash held by their corresponding mutual funds. Even small amounts can drag on a mutual fund's performance relative to the ETF clones.

Much of a bond’s total return comes from interest income, which is taxed the same regardless of vehicle. ETFs limit capital gains, so they could help the tax efficiency of longer-duration and credit-sensitive strategies.

Conversely, ETFs’ tax efficiencies are lost on strategies with low duration and credit risk, such as ultrashort high-quality bond funds.

Warren Buffett has a famous saying: “Only when the tide goes out do you discover who’s been swimming naked.”

ETFs’ transparency exposes them for what they are, benefiting some and hurting others.

As the ETF market grows more diverse and complex, our complete, timely, and independent data can help you make the most of it.

Morningstar’s ETF data, research, and insights give you the complete view you need to investigate your portfolio.