Active ETFs in portfolio construction

Active ETFs: A game changer for ETFs?

Interest in active ETFs is on the rise. Hundreds of new funds have been launched in recent years, and assets have nearly tripled since 2020, to over $400 billion as of October 2023.¹ What's behind the enthusiasm? 

While active ETFs have been around for well over a decade, a surge in issuance began in 2019, when regulatory changes made it easier for new issuers to enter the market. While many well-known active managers launched their first ETFs shortly thereafter, investors didn't follow immediately. 

Most investors prefer investing in funds with at least a three-year track record. That way, investors can better evaluate not only performance, but also whether the managers of these new ETFs were able to deliver on their active mandates and offer enhanced tax efficiency relative to traditional mutual funds. With many active funds having now passed that critical three-year threshold, fund flows have begun to follow. 

So, do actively managed ETFs have a role to play in your portfolios? Here are a few features and factors to consider when contemplating incorporating active ETFs.

ETFs as Building Blocks

Since their development in the 1990s, ETFs have become building blocks many advisors turn to when constructing client portfolios. Their potential tax advantages, transparency, and generally low fees have helped make them a compelling option for investors when seeking broad market exposure. In addition, ETFs are traded intra-day, unlike mutual funds, making them a more liquid and flexible option when executing trades.

Active ETFs retain many of those appealing features. They also offer intra-day trading, potential tax efficiency, and often lower fees than comparable active mutual funds. While many active ETFs also offer the transparency of passive ETFs, some "semi-transparent" active ETFs do not report holdings daily, but rather with a lag.* 

More compellingly, active ETFs also offer many of the virtues of active mutual funds. Many active ETFs seek to outperform their benchmark through security selection. Active ETFs can also be used to package countercyclical investment strategies. And their managers have the ability to adapt the fund's holdings in response to market conditions.

When it comes to building out portfolios, active ETFs can be a valuable diversification tool. Many active ETFs are designed to fulfill the core building block role of their passive brethren, but with the additional value that may be provided by active management. These may include bottom-up, fundamental research-driven selection strategies, quantitative risk modelling designed to improve risk/return ratios, or a combination of both. In principle, these solutions can often offer an advisor ways to effectively target the same core exposures but with the possibility of additional alpha. 

The diversification benefits of active ETFs are not restricted solely to core strategies. With the explosion of offerings in the space in recent years, almost every investment strategy or style can now be found in an active ETF format: Of the 122 categories by which Morningstar divvies up the universe of investment funds, active ETFs have been launched for more than 100.²

In particular, they may allow access to sector tilts; factor tilts, such as quality, value or growth, low volatility, momentum, dividend yield or size (such as small cap); or investment themes such as disruption, megatrends, or outcomes tied to long-term expectations, like inflation. 

Here are some reasons why you might consider using active ETFs:

• Professional management. Active ETFs are typically managed by experienced portfolio managers who make investment decisions based on their research, analysis, and expertise.
• Potential alpha generation. Whereas a passively managed ETF attempts to track the performance of a benchmark, actively managed ETFs have the potential to earn higher returns.
• Potential tax efficiency. Like passive ETFs, active ETFs can use "in kind" baskets of securities to create and redeem shares, generally generating fewer capital gains than comparable mutual funds. In 2022, a bearish year for markets, 61% of active equity mutual funds generated capital gains, compared to just 11% of active ETFs (see chart).
• Targeted allocation. Some active ETFs focus on specialized themes or sectors that are not well-represented in traditional index funds. This allows investors to gain exposure to niche markets or investment strategies that align with specific goals or values.

Conclusion

As the active ETF segment grows, there are fewer and fewer fund styles or strategies that can't be found in an active ETF format. This innovative investment wrapper has led to greater access for advisors who are seeking the benefits of ETFs as a part of multi-asset class solutions and who believe in the potential of active management.