Actively managed ETFs may soon be all the rage

For most investors, exchange-traded funds are synonymous with passive investing. The wealth management industry is trying to change this, but probably not for the better.

ETFs have been a big market topic in recent years. Over the past decade, assets managed by these vehicles in the U.S. have ballooned from about $1.5 trillion to more than $10 trillion, according to Wall Street analysts.

At least for now, most of that money is managed passively. Active vehicle assets are less than $1 trillion worldwide. The highest amounts of money still flow to the top companies at BlackRock, Vanguard and State Street, which charge less than 0.1% to track the benchmark S&P 500 and similar indexes.

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Thanks to the index fund mania, these three asset managers have grown into the world's leading financial forces, with a combined total of about $25 trillion in assets under their supervision. Vanguard's flagship tracker fund, which dates back to 1976, operates like a “random walk” in which stock movements effectively price new information, rendering any attempt to beat the market meaningless. This was backed up by research that showed that.

But selling products that track indexes like the S&P 500 or the MSCI World Index is a low-margin, commoditized business. As a result, many mid-sized asset management companies that do not have the scale to compete are losing their lives. Even the Big Three are eager to expand into higher-margin product lines.

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The 2010s saw a surge in the creation of “smart beta” ETFs, which screen indexes according to preset rules, ranging from simple equal weighting of stocks to tilted allocation to multiple “factors” with exceptions. It's for this reason. Generate excess returns based on the “efficient market hypothesis”. Since then, ETFs have expanded to encompass all kinds of strategies, including ESG, which is investing based on environmental, social, and corporate governance criteria.

Active ETFs are the latest attempt at differentiation and seem to be bringing investors full circle. That means they end up paying more to underperform, ignoring the long-held wisdom that active managers often struggle to beat the broader market after fees are taken into account.

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So far this year, active launches have outnumbered passive launches by more than 3 to 1, according to Morningstar Direct. In 2014, this ratio was almost the opposite. Regulation changes by regulators in 2019 played a major role in the proliferation of these products.

My grades aren't good. Over the past 15 years, these vehicles have delivered an average annual return of 12.4% in blue-chip U.S. stocks. This compared to 13.5% for passive peer funds and 12.6% for active open-end mutual funds. Fees, which average 0.31% for active ETFs and 0.07% for passive ETFs, are a drag on performance.

Indeed, it makes sense for active ETFs to replace comparable mutual funds. The former are more liquid, at least in many jurisdictions tax-efficient, and cheaper, and active ETF fees are still about half that of active mutual funds.

A recent study by analytics platform Trackinsight found that diversification is the number one reason investors choose active ETFs, helping to explain why the most popular ETFs often veer toward niche approaches.

The best-known example is Cathie Wood's high-growth technology fund ARK Innovation, which has lost much of its luster since 2021. Another hit product is the JPMorgan Equity Premium Income ETF, which sells covered calls to reduce stock price volatility. stock portfolio. Thanks to the recent craze for options-related strategies, this has become the world's largest active ETF.

The second most popular active ETF, Dimensional Fund Advisors' U.S. Core Equity 2 Fund, is biased toward small-cap stocks. According to Morningstar Direct, these products are the only segment of U.S. equities that are outperforming. Many of these companies do not receive coverage from Wall Street analysts, giving them greater stock-picking benefits.

For bond ETFs that cover illiquid assets, additional flexibility to deviate from the index may also be beneficial. In fact, active outperforms passive in terms of pre-fees performance.

So the boom in active ETFs could be a good thing for some sophisticated investors, as long as they follow the same rule of thumb that led to the success of passive vehicles: favoring the cheapest option. The potential gains from active management are still small, so lower fees can make a big difference.

“One of the best predictors of active fund performance is expense ratio,” said Jeffrey Johnson, head of fixed income products at Vanguard, which is currently working on launching two active ETFs in the municipal bond market. There is.

Nevertheless, as investment firms incorporate more complex collections of assets and strategies into ETF wrappers, the likelihood that customers end up paying for the wrong product increases. For example, selling covered calls is a surefire way to miss out on big profits on an uptrend with unlimited downside risk.

Investors who are tempted to forego passive ETFs should make sure they are following their own interests, not those of the investment industry.

Email Jon Sindreu. jon.sindreu@wsj.com