Actively managed ETFs may soon be all the rage

For most investors, exchange-traded funds are synonymous with passive investment. The asset-management industry is trying to change that—and likely not for the better.

ETFs are the big market story of the past few years: Over the past decade, assets managed by these vehicles in the U.S. have leapt from roughly $1.5 trillion to more than $10 trillion, according to Wall Street analysts. 

For now at least, most of that money is managed passively. Active vehicles look over less than $1 trillion in assets globally. The largest sums still flow to the top vehicles from BlackRock, Vanguard and State Street that charge less than 0.1% to track the benchmark S&P 500 and similar indexes.

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Index-fund mania has helped turn these three asset managers into some of the world’s dominant financial forces, with combined assets under supervision of about $25 trillion. Vanguard’s flagship tracker fund harks back to 1976, and was backed by research that showed equity moves behave like a “random walk” that efficiently prices new information, which would render moot any attempt to beat the market.

However, selling products that track gauges such as the S&P 500 or the MSCI World Index is a low-margin, commoditized business. That is killing many midsize asset managers who lack the scale to compete. Even the Big Three are eager to expand into higher-margin lines.

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This is why, in the 2010s, there was a surge in launches of “smart beta” ETFs that screened indexes with preset rules, ranging from a simple equal-weighting of stocks to tilting allocations toward multiple “factors” that are supposed to be exceptions to the “efficient market hypothesis” and generate excess returns. ETFs have since expanded to become a wrapper for all sorts of strategies, including ESG—investing based on environmental, social and corporate-governance criteria.

Active ETFs are the latest attempt to differentiate, and they seem to be taking investors full circle. That is, paying more to get less performance—and ignoring the longstanding wisdom that active managers often struggle to beat the wider market after accounting for fees. 

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So far this year, active launches outnumbered passive ones by more than three to one, according to Morningstar Direct. The ratio was roughly the other way around back in 2014. A 2019 rule change by regulators has played a big role in making these products ubiquitous. 

The performance record isn’t great. Over the past 15 years, these vehicles have delivered an average annual return of 12.4% in U.S. blue-chip stocks, compared with 13.5% for their passive brethren, or 12.6% for active open-ended mutual funds. Fees, which average 0.31% for active ETFs and 0.07% for their passive counterparts, add to the performance drag. 

To be sure, it makes sense for active ETFs to replace equivalent mutual funds. The former are liquid, tax-efficient—at least in many jurisdictions—and cheap, with active ETF fees still roughly half those on active mutual funds.

Diversification is the top reason why investors choose active ETFs, a recent survey by analytics platform Trackinsight shows, which helps explain why the most popular often veer into niche approaches. 

Cathie Wood’s high-growth technology fund, ARK Innovation, is the best-known example, though it has lost a lot of its luster since 2021. Another hit is the JPMorgan Equity Premium Income ETF, which sells covered calls to reduce the volatility of its equity portfolio. It has become the world’s largest active ETF thanks to the recent craze for option-related strategies. 

The second-most-popular active ETF, the U.S. Core Equity 2 fund from Dimensional Fund Advisors, has a bias toward small-caps. According to Morningstar Direct, this is the only segment within U.S. equities in which these products outperform. Many of those companies receive no coverage by Wall Street analysts, which increases the benefits of stock picking. 

For bond ETFs, which handle less-liquid assets, some extra flexibility to deviate from indexes can sometimes be beneficial too. Indeed, active beats passive in terms of pre-fee performance.

So the boom in active ETFs may be good for some sophisticated investors, as long as they adhere to the same rule of thumb that has led to the triumph of passive vehicles: Prefer the cheapest option. Because the potential gains from active management are still small, a low fee makes all the difference.

“One of the best predictors of active-fund performance is its expense ratio,” said Jeffrey Johnson, Vanguard’s head of fixed income product, who is now working to launch two active ETFs in the municipal-bond market.

Nevertheless, as investment firms put more complex collections of assets and strategies into ETF wrappers, the likelihood increases that clients will end up paying for unsuitable products. Selling covered calls, for one, is a sure way to miss out on big gains during rallies while retaining unlimited downside risk. 

Investors who feel tempted to venture out of passive ETFs should make sure they are following their own interests and not those of the investment industry.

Write to Jon Sindreu at [email protected]