Active ETFs: What Investors Need to Know

Sarah Hansen: Welcome to Investing Insights. I’m Sarah Hansen, the markets reporter at Morningstar, and I’m filling in for Ivanna Hampton today. We’re on the podcast stage at the 2024 Morningstar Investment Conference at Navy Pier in Chicago. And today we’re talking about active ETFs. These have soared in popularity, seemingly overnight. They’re gaining market share at a rapid clip, and they’re being recognized as a long overdue opportunity for active managers and, not to mention, a new cost-effective tool for investors.

So, what is driving all of this growth? Luckily for us from Morningstar Research Services, we have Bryan Armour, who is the director of passive strategies research for North America; we have Daniel Sotiroff, who is a senior manager research analyst; and we have Ryan Jackson, who is a senior manager research analyst of passive strategies. And they’re here to tell us everything investors need to know. Thank you so much for joining me.

Active vs Passive ETFs

So, first things first. Bryan, maybe you can help me with this one: What are active ETFs? How do they work and how are they different from passive ones?

Bryan Armour: Great question. ETFs are really just mutual funds that trade on a stock exchange. So, structurally, they’re very similar. The big difference is they tend to be a bit more tax-efficient; last year, 4% of ETFs distributed capital gains and 60% of mutual funds did. And they tend to be lower-cost. If there’s a similar mutual fund, an ETF would be at a cost that’s similar to the institutional or a retirement plan share-class fee level. Both are very easy wins for investors. It’s clear why investors are excited about them. And then in terms of active versus passive, it’s really just passive will track an index. There’s a methodology. What they’re putting in their portfolio, when, and how much is all dictated by an index. Whereas for an active manager, they would have discretion over those decisions.

What’s Driving the Growth of Active ETFs?

Hansen: Great. A lot of the growth we’ve seen has been on the active side. Ryan, maybe you can tell us what’s driving that momentum, and if you expect it to continue.

Ryan Jackson: A ton of momentum into active ETFs. It’s been fast and furious. Just to kind of put it in context, you look at active ETFs at the end of May of this year compared to three years ago, today have about 4 times the amount of assets and 3 times the number of products. So, there’s been a huge proliferation, not just in the number of products available, but the money that actually sits inside of them.

And when you think about what’s driving that growth, I tend to look at it both from a supply and demand angle, both things kind of working together. So, on the supply side, the big catalyst was the ETF rule passing in 2019. And this was a piece of SEC legislation that made it a lot easier for, a) providers to even bring ETFs to the market in the first place, and b) for active managers to use custom baskets to create and redeem new shares. Without getting too far into it, it really allowed them to tap into the tax efficiency of the ETF vehicles. So, since that passage of the ETF rule in 2019, we’ve just seen the number of products available to investors really skyrocket.

So, that’s the supply, but that’s no good if there’s not actual demand for those products. And there’s definitely been a ton of that. I think it took a little while for investors to kind of get comfortable with the ETF as a structure, maybe disentangle the idea of ETF and passive, which had existed for so long. But once that happened, we’ve seen them warm up to the transparency, the tax efficiency, and the cost advantage that comes with ETFs, and that demand has certainly taken off since.

Why Some Active ETFs Are More Successful Than Others

Hansen: Amid all this momentum, there’s been some that have been more successful and gotten a lot more uptake than the rest of the pack. Dan, why has that happened and what’s driving that?

Sotiroff: Yes. So, maybe just take a step back. What has been really successful? When we look at the leaderboard, there are some clear winners out there. We have JPMorgan Equity Premium Income JEPI, which I think is number one or number two based on the table you guys put together in your research. That’s a covered call strategy, essentially, that’s based on the S&P 500. They have another one, JEPQ, which is based on the Nasdaq 100. And then J.P. Morgan has another ultra-short-term bond ETF that’s actively managed. That’s done very, very well in terms of gathering assets.

So, when I look at those three, it really screams income to me. The short end of the curve is the higher-yielding segment of the curve right now, so you’re in ultrashort bonds. And then those covered call strategies are really more of a novel income play that we’ve seen come out over the past few years. Those three are really saying income to me.

The rest of the list is—it’s no surprise to me, but the rest of it is a lot of DFA and Avantis-type stuff out there. So, very low-cost, very broadly diversified ETFs at the end of the day. It’s very easy for a lot of advisors and investors to rationalize those types of things in their portfolios. Being that they’re broadly diversified is very easy to understand how these things are going to perform, and why they’ve outperformed or underperformed over any given period. So, it’s very easy stuff to understand. Very low-cost, too. They have a massive fee advantage over a lot of other actively managed funds. So, they’ve been doing very, very well.

The other thing with that dynamic, though, is when you look at DFA, we’ve seen a lot of outflows from their mutual funds and a lot of inflows to their ETFs. So, I think some of that is just their advisors and their investors rotating out of the mutual funds and into the more tax-efficient—like Bryan was saying before, ETFs are just a more tax-efficient wrapper to get into. I think that’s really what’s driving a lot of the success on the DFA and the Avantis side of things.

Active ETFs That Managers Have Shied Away From

Hansen: What about the other side of the coin, the ones that just aren’t as popular? What’s happening there and why aren’t they getting picked up?

Armour: I guess the number-one thing I would say is obviously we all live in the ETF world every day, and so we talk a lot about low costs. And that’s no surprise. It’s basically table stakes in the ETF market. So, high-fee strategies, traditional mutual fund managers that are able to charge high fees, have not had a ton of success in the ETF wrapper. It’s not a panacea. Everyone doesn’t just automatically catch the trend by launching an ETF. That’s one area where it hasn’t worked, and there has not been a ton of new product development.

Another one is ETFs can’t close to new investors. Capacity risk is something that active managers have to think about, especially in more niche areas of the market. And with the mutual fund, if your strategy starts to become impaired by the size of the fund, then they could close to new investors. And for ETFs, they can’t do that. So, some of the more concentrated strategies haven’t come to market in the more niche areas, but there are still the more broadly diversified active strategies that have done well there. And then the last thing is allocation ETFs. It’s sort of a solution in search of a problem in the sense that the tax efficiency doesn’t always help for allocation because it’s typically going to be in a retirement account or something like that where it’s tax-advantaged. They might not need the tax efficiency. And then on top of that, you’re mixing stocks and bonds. You have multiple asset classes. Market makers are going to have to be able to price that portfolio well, hedge it, and step in if there’s a premium or discount. For market makers to make tight bid-ask spreads, the less complicated, the better. And so, it just really hasn’t taken off from either an investor interest perspective or in terms of just the plumbing of the ETF market.

Hansen: So, those super specialized options are maybe not attracting.

Armour: Right.

Who Should Invest in Active ETFs?

Hansen: Given what Dan mentioned and what you mentioned, it seems like there are lots of pros and cons within the space. Who is a good candidate for this kind of investment? Who can look at the list and say, these pros are for me? Or who should shy away based on the cons that we just talked about?

Jackson: I think first and foremost, if you’re a believer in active management, then this is potentially a good option for you. It’s something you would ideally be keeping in a taxable account to really reap the benefits over a mutual fund. But when you look at the strategies that might be conducive for the ETF wrapper, you need to start with, again, is this a good place to go active? We publish an Active/Passive Barometer every year where we’re comparing in different Morningstar Categories how active funds perform relative to a composite of their passive peers. So, it’s a little bit more of a realistic alternative, I guess, than a benchmark. And we find that there are certain pockets of the market where it might make more sense to be active. That’s kind of the place to start before you even make the mutual fund versus ETF decision: Is active a good spot for me?

A couple of examples there. The international active management tends to be a little bit more successful, fixed income pretty much across the board, and even in small caps is a little bit easier than something like US large caps where it’s really tough to compete. So, that’s the first step.

Number two is thinking about, “OK, could some of those drawbacks to the ETF structure really come into play and hurt me here?” So, Bryan was just mentioning capacity being a potential issue where you can’t close to new investors. If it gets too big, all of a sudden, you’re running into problems. So, if you’re looking at something like small-cap, which again is very conducive to active management, you might start to run into issues where you really grow out of control, getting a little too big, too hefty to move in and out of new trades easily. So, maybe an ETF doesn’t make sense there.

I think was it you that coined “active ETF paradox,” the term? The idea that in the spaces where it makes most sense to be active, that might be some of the same areas where it’s most challenging to be in an ETF. So, there’s a little bit of a push and pull to it and just reiterates the importance of having a look into each strategy on a one-by-one.

Sotiroff: We’ve seen some problems with that just recently. Cathie Wood’s ARK ETF had some capacity issues. She started putting a lot of money into a lot of smaller stocks that were not really on her radar and stuff like that. So, you’ve clearly seen some problems with some active ETFs.

Hansen: Bryan, since you coined it, anything to add on the paradox of the ETF, the active ETF?

Armour: No, not really. When you think about large blend. It is a really good spot for market makers for capacity, and it’s the worst area for active managers to seek alpha. It ends up being a bit of a balancing act for active managers to test “Where can we add value, and where can we effectively deploy the strategy in an ETF?”

Misconceptions About Active ETFs

Hansen: As this grows and gains momentum and gains interest from investors, there’s bound to be things that get circulated that aren’t right, misconceptions. Dan, what would be the biggest one, the biggest thing that’s just wrong that’s circulating out in the world?

Sotiroff: I think the single biggest misconception is just how all this has been framed in a lot of media and the headlines and stuff. You read the headlines and you think, “Oh, active stock-pickers are all of a sudden having this massive resurgence and they’re coming back to life.” And that absolutely is not the case. Going back to what I was saying before with who are some of the top winners, it’s a lot of rules-based strategies at the end of the day, this stuff from DFA and Avantis, even some of the J.P. Morgan covered-call strategies I talked about before that have been very successful. Those are all essentially sort of rules-based strategies behind the scenes. They’re not really active stock-pickers at their core.

Now, we have seen some success in those areas. I think of T. Rowe Price, Fidelity, and Capital Group. They’ve had some decent success there. They’ve had some ETFs that are doing pretty well. They’ve got a billion, a few billion dollars, so they’re viable. But when you look at the biggest ETFs out there, it’s not this renaissance in active stock-picking or active bond-picking that the headlines seem to make it out to be. I think that’s the single biggest misconception that we need to get clear. It’s really more of the rules-based, we’ll be active around the edges type of stuff at the end of the day. And that’s great. Those are great investments by all means. So, it’s not necessarily a bad thing. It’s just misunderstood, I think.

Armour: One thing I wanted to add, too, is I was shocked when you see the headline numbers. You can just see how explosive the active ETF market has been. But when you dig in deeper, the breadth of success is not really there. There have been a few asset managers that have had a lot of success. There have been a few funds that are just killing it, especially in smaller categories where there’s one or two with over a billion in assets, and that’s it.

And then another thing is just the innovation of ETFs, in general. There’s been a big shift into options-based. So, options-based strategies are very high in terms of their market share of the active ETF market as compared to what you would think of as active mutual funds, the different areas of the market share there. So, it is a little different. It’s still very early though. It’s 4% of the active market, including mutual funds and ETFs. So, it’s early days, and these are things that will be fixed over time, but as of now, it’s a little tighter on what’s been successful.

Hansen: So, we’re growing, but we’re growing on the margins.

Sotiroff: I’ll throw one more thing in there, too, sort of related to that. We saw a lot of mutual funds converting to ETFs. Or at least it was kind of a hot thing about a year ago, right? It was a big thing. Some people thought there was going to be this tsunami of mutual funds converting to ETFs. It was very much sort of the same story that we’re talking about. You saw a very limited amount of success. DFA converted, I think, it was seven of their mutual funds into ETFs. Those took off. It was like they were on rocket fuel. And the rest, I think there was another like 70 or some that have converted since. It was like, “Nah.” Nobody was really after them. They didn’t seem to gather a lot of assets. In fact, we actually saw some of them see outflows after they converted. So, it’s not the story that a lot of the headlines are making it out to be.

Hansen: Got it. It can be tempting to write that headline and say it’s huge and it’s exploding.

Sotiroff: It’s very tempting and very click-baity at the same time. But yes.

Top-Rated Active ETFs

Hansen: Amid all that kind of mediocrity and maybe the ones that aren’t doing so well, what does Morningstar like? What are the funds that you think are doing it right or are successful or well-managed? What are you looking at and saying that’s the one?

Armour: I would put different strategies in three buckets. Dan referenced Dimensional and Avantis, that’s more like “systematic active” is what we like to call it. So, for those types of funds, obviously, Dimensional and Avantis have had a lot of success. We rate them highly. We think highly of the strategy. It’s sort of a mix between active and passive, I would say. There’s an active trading component, but it’s very formulaic in how they build the portfolios. Dimensional US Core Equity 2 DFAC, for example, is one that we rate highly, and that’s almost like a US total market ETF, but they tilt toward things like smaller companies, cheaper valuations, and more profitable companies. And then Avantis takes a similar tack with Avantis International Equity ETF AVDE, but they do a really good job also of navigating through active management, some of the inefficiencies, sort of regionally dealing with local tax laws, things of that nature. Those are really good options for systematic active.

The second bucket is the more traditional discretionary active. The two that jump out to me are Capital Group Dividend Value CGDV, which is relatively new, but we’re familiar with the portfolio managers and the teams. The strategy echoes some of the existing American Funds mutual funds. That’s a Silver-rated fund. Over the past year, it’s performed in the top-five percentile of its category. And then Fidelity Total Bond ETF FBND is another one that we think highly of on the fixed-income side. And that’s a core-plus-type strategy where they take that the Agg [Bloomberg U.S. Aggregate Bond Index] sectors, where they have government bonds or Treasuries, corporate debt, and securitized debt, and then they add on up to 20% in high yield or emerging markets. And so that’s another one.

And then the third bucket is options-based, which I just referenced. Dan mentioned J.P. Morgan’s strategies. JEPI is a great example. It’s the biggest active ETF. And what they do is sort of like a fundamental equity sleeve that is intended to be a little bit lower vol, and then they write calls against it, which drives down the beta to the market even further and generates some income. And that’s a Bronze-rated fund. So, we think highly of all of those. And the unifying characteristic is low fees,once again.

Jackson: Sorry to jump in. I like that you bucket it into different degrees of active, almost. And it’s such an important point, because I think so many of us, myself included, sometimes are guilty of just thinking broadly passive or active, just kind of on this binary scale. But there’s so much nuance in between. And it’s important to sort that out and understand how far away from the market am I really going with something like an Avantis strategy. So, there are a whole lot of shades of gray in the middle, for sure.

Hansen: It sounded to me when you were laying out the top ones, the ones you like, that there’s kind of careful consideration of the active piece of the management of these funds. Is that a fair way to sum it up?

Armour: Absolutely.

What’s Next for Active ETFs?

Hansen: Great. And then, Ryan, maybe you can talk a little about what’s next. Are we going to see more funds like these? Are we going to see the industry keep taking off? Is it a flash in the pan? What’s ahead?

Jackson: It definitely feels a little bit like a blank canvas right now. To get back to Bryan’s point, you said 4% of the active fund market. I know when you layer in passive ETFs and mutual funds, it sinks down to about 2%. In the grand scheme of things it’s still a sliver of the full market available to it. But when I kind of look ahead at the future of the market specifically, we’ve seen with other iterations of the ETF world before, things like smart beta, thematic funds, ESG, to a smaller scale had a rise and then a little bit of a trimming where we saw people fall out of love with them a little bit. Maybe a lot of fund providers realize just because it worked for some doesn’t mean it will work for us, and you see the market start to tighten up a little bit. I wouldn’t be surprised to see a little bit of a narrowing when it comes to just the products available to investors. It’s a big lift for fund providers to get an ETF off the ground and stand it up. And it wouldn’t shock me to see a lot of them realize it’s just not worth the squeeze. That said, it is still such a huge addressable market for active ETFs to take.

And the one potential monkey wrench that’s out there is this idea of ETFs as a share class, pending approval from the SEC. We don’t know if that’s going to happen or not. I don’t know if I can even speculate on it. But potentially a huge engine there where a lot of fund providers wouldn’t have to go through the process of starting a brand-new strategy from scratch but rather just bolt it onto an existing mutual fund. So, if we see that go through, it may be a big inflection point in terms of the active ETF market.

Hansen: It might not be the tidy, neat, linear march upward. It could be bumpy.

Jackson: I would almost expect that. You look at the way it’s been so far, it kind of started on this very slow, mild growth. And then the ETF rule was inflection point number one, where you saw the huge jump following 2019. I can’t guarantee that ETFs as a share class would have the same impact or anywhere close to it even. But it’d be almost surprising to see a really gradual linear growth for the market.

Sotiroff: But we know there’s a lot of interest on the part of asset managers. There are something like 17 or 18 filings out there. There were two that came out just last week. So, asset managers are clearly keen to get on that ride, for sure.

Hansen: As that happens, as the interest grows and as asset managers and advisors take note, what should investors remember? If someone is trying to pitch them on an active ETF or if they’re thinking about it or reading headlines, what’s the one thing to take away?

Sotiroff: I’ll give you a short answer and then a long answer. The short answer is when you look at an investment, you have the process and the people, and I think those are going to become even more important as we go forward. If you go back over the last 10, 15, you could even say 20 years, you saw a lot of index-tracking ETFs were getting very, very competitive on fees. You’d see Vanguard would cut the fee on Vanguard Total Stock Market VTSAX by a basis point, and then Schwab would come out two days later and do that, and then BlackRock would follow another day or so after that. So, you had these fee wars going back and forth on a lot of index-tracking ETFs.

There were two benefits from that. One, you got your index fund for a lot cheaper than what it was before, but it also sort of stiff-armed a lot of the active managers to cut their fees to become more competitive. Now we’re sort of seeing a similar dynamic play out with tax efficiency. You’ve seen a lot of index-tracking ETFs have had this sort of built-in advantage of tax efficiency in the background. Well, now active managers, now that Ryan said the ETF rule passed in 2019, they can get into ETFs now, and they can become more tax-efficient in theory if it works with their strategy. So, you’re seeing that same sort of thing now where they’re sort of being forced into the ETF wrapper in order to remain competitive, and in some cases, remain relevant, I think.

Basically what’s happening is the playing field is starting to level. Fees are coming down. Low fees have become more common. Tax efficiency, ETF access are becoming more common. Now that those things are out of the way, now you’re going to have to pay more and more attention to what’s actually going on in the background. What is the investment process? Who is managing this? How are they trading? All those nuts and bolts, they were always really important. I mean, they’re always part of our valuation process. But they’re only going to be more and more important going forward as those other side things that were always an advantage for index-tracking ETFs become more prevalent. I think that’s really where this is going.

And, by the way, that’s a great thing for all of us as investors, right? Who doesn’t want a more tax-efficient investment at the end of the day? Who doesn’t want lower fees? We know lower fees, all else equal, it’s an objective advantage by far. So, we should all be jumping up and down as investors because it’s a great thing for all of us at the end of the day. I’ll drop the mic there on that.

Hansen: Fantastic. That’s a great way to end. I’m looking at our countdown clock, which is rapidly ticking. So, thank you Bryan, Dan, and Ryan for joining me up here at the Morningstar Investment Conference 2024.

That is going to wrap up this week’s episode. The team will be taking off next week for our listeners for the 4th of July, and Investing Insights will be back on July 12. If you’re listening, we ask that you leave us a 5-star review on Apple Podcasts so other people can find us. You can watch us on YouTube also and subscribe to Morningstar’s channel to see more of what we do. And then I’ll do special thanks to our senior video producer Jake VanKersen, our lead technical producer Scott Halver, our senior audio engineer and producer George Castady, and our associate multimedia editor Jess Bebel.

I’m Sarah Hansen. I’m a markets reporter at Morningstar. Thanks so much for joining us.