Why Invest in Actively Managed ETFs

• Active ETFs are growing faster than the broader industry, as choice and adoption have expanded.
• Traditional active ETFs retain the benefits of the ETF wrapper, such as transparency and trading flexibility, with no visible sacrifice on alpha.
• Active ETFs also offer improved tax efficiency over active mutual funds.

ETFs are widely recognized as a primary vehicle for passive investment strategies. The first ETF was an index fund, and 94% of US-listed ETFs are index-based.¹ In recent years, however, actively managed ETFs have been gaining traction.

The case for active management, regardless of wrapper, comes down to two use cases: seeking potential alpha generation from market inefficiencies, or producing specific outcomes while managing risks. In addition to those goals, active ETFs are able to provide many of the same benefits as indexed ETFs thanks to the operational structure of the ETF itself. Traits like daily transparency, potential for improved tax efficiency, dual avenues of liquidity arising from both the primary and second market, as well as flexible trading characteristics allow for more sophisticated implementation strategies.

The ability to retain both the potential for producing specific outcomes as well as operational efficiencies and flexibility affords active ETFs specific potential advantages over mutual funds and other investment vehicles. These are just some of the reasons why the market has grown in recent years, and is expected to continue to evolve.

Growth of Active ETF Assets Outpacing Passive

The first active ETF was launched in 2008. Since then, over 1,000 active ETFs have been launched and there are now 1,115 actively managed ETFs available today.² With so many products available, naturally choice has expanded. For example, in 2012, active ETFs covered 39 different Morningstar categories. This coverage has expanded rapidly, increasing to cover 62 categories in 2016, 76 categories by 2020, and today coverage spans 88 different categories.³ The greater choice and strategy types for investor usage has naturally generated more interest — and adoption. There are also more funds that now have identifiable three- and five-year track records, an important part of due diligence.

After 39 consecutive months of inflows, active ETFs now have over $420 billion in assets.⁴ While this is still below the $6.8 trillion in indexed-based ETFs, the growth rate active ETFs have seen has been far greater. As shown below, active ETFs’ five-year compound annual growth rate (CAGR) of 48% is more than three times the rate for passive ETFs — and the industry overall. And over those last five years, cumulative flows into active ETFs (+$327 billion) totaled more than 555% of start-of-period assets ($59 billion) versus a modest but still impressive 70% for passive ETFs.⁵

With more than 100 active ETF launches already in 2023, more choice is coming to the market, and that may continue to propel adoption.⁶ In fact, nearly 70% of advisors and retail investors surveyed by Mitre Media in Q1 2023 said they intend to purchase shares of an active ETF in the future.⁷

Traditional Active ETFs Deliver Transparency

Understanding the ins and outs of a given investment is an important responsibility — especially so when investing in actively managed strategies where due diligence is critical to understanding a manager’s process and philosophy, and dissecting performance trends. To truly gain this understanding, investors need transparency.

That’s where the ETF wrapper shines, empowering investors in actively managed funds to know exactly what they own at any point in time. Fully transparent, traditional active ETFs disclose complete holdings information each trading day. If, say, a value manager drifts towards growth stocks or a core bond strategy increases exposure to more illiquid credits, an investor can track this each day.

In contrast, mutual funds commonly disclose their full portfolio holdings on a quarterly or monthly basis — usually published with a lag. As a result, tracking exposure changes happens in arrears. If a portfolio strays from the intended objective in order to chase performance, it may not be known until it’s too late.

It’s worth noting that semi-transparent ETFs are a distinct vehicle with different disclosure requirements, and typically disclose holdings on a time lag, too. Nonetheless, fully transparent, traditional active ETFs offer investors much more transparency than actively managed mutual funds. This provides investors with greater clarity for due diligence and monitoring, helping active ETF users detect risks in real time.

Improved Liquidity and Tax Efficiency 

ETFs, in general, also tend to be more liquid and tax-efficient than mutual funds as a result of their intraday trading and unique in-kind creation/redemption mechanism.

ETFs actually benefit from two sources of liquidity: (1) the secondary market, where most investors buy and sell shares on exchanges at market prices throughout the trading day, and (2) the primary market, where authorized participants (APs) can build baskets of ETF shares when demand increases (creation) or disassemble the baskets of ETF shares back into single securities should demand decrease (redemption).

Because of this in-kind “basketing” mechanism, ETFs can avoid selling shares to raise cash for redemptions. As a result, they tend to distribute fewer capital gains than mutual funds. This is because the mutual fund structure does not allow for the in-kind “basketing” mechanism. Instead, they operate on a cash basis, selling securities to meet shareholder redemptions.

While some active ETFs will utilize a cash create/redeem mechanism, as some securities may not be “in-kindable” (i.e., certain fixed income securities, emerging market equities, etc.) or if the portfolio manager feels this provides more flexibility, the dual layers of liquidity still provide potential tax benefits.

For example, not all investor activity has to hit the primary market because of the presence of the secondary market. Natural two-way order flow on the secondary market can be abundant enough, with buyers and sellers meeting on exchange to transfer shares. As a result, the underlying portfolio is shielded from one investor’s actions and the portfolio manager does not need to raise cash by selling securities — possibly incurring capital gains — to meet a redemption. Mutual funds do not have this functional/structural benefit.

This is not a theoretical advantage or example, either. Some active ETFs trade more than $100 million a day on the secondary market, and overall active ETFs secondary-to-primary-market ratio is 4:1.⁸  This means for every $4 invested, only $1 hits the primary market.

So, whether an active ETF leverages the in-kind creation/redemption process or not, there are potential liquidity and tax-efficiency benefits. The latter is evident when considering that, on average, only 13% of all active ETFs paid capital gains over the last five years compared to 57% for active mutual funds.⁹  In fact, over the last five years, the percentage of active ETFs was never more than 25% (see the chart below). Meanwhile, the active mutual funds capital gains rate never fell below 50%.

Increased Trading Implementation Flexibility

Mutual fund shares are bought and redeemed at day-end net asset value (NAV), whereas ETFs offer intraday pricing in the secondary market. As such, ETFs offer investors more flexibility and greater support for different trading styles and habits.

ETFs, for example, allow investors to rebalance different exposures throughout the day as well as purchase ETF shares on margin and sell ETF shares short. Mutual fund investors face a more rigid trading environment — for example, they receive the same price regardless of whether a trade is placed at 10:00am or 3:50pm, curtailing the ability to quickly navigate changing market conditions and implement trading tactics.

The real-world impact of this is felt when mixing mutual funds with ETFs to construct portfolios. The ETF allocations can be rebalanced throughout the day using a variety of trading strategies, while the mutual fund proceeds/costs will remain unknown until later that day. It creates rebalance asymmetry and introduces final allocation uncertainty, since there is a time delay to the execution.

Put Active ETFs Into Action

All of the potential benefits mentioned above for active ETFs do not come in lieu of weaker performance/alpha potential versus active mutual funds. In fact, the amount of active ETFs outperforming their benchmark over the last five years (39%) is the same as active mutual funds.¹⁰  When breaking it out by asset class, active bond ETF managers did better than active bond mutual fund managers, as 59% of the ETFs beat their benchmark while only 38% of mutual funds did.¹¹

Given the expanding choice, greater transparency, improved tax efficiency, and more abundant liquidity, it might be time to put active ETFs into action in portfolios.

For more information about ETFs in general, visit our ETF Education center.