Active ETFs manage to shine even as mutual funds take a battering
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Exchange traded funds are proving a rare ray of light for under-fire active fund managers as mutual funds are decimated by a toxic cocktail of investment losses and unprecedented outflows.
Globally, investors pulled a net $640bn from actively managed mutual funds in the first half of the year, according to figures from Morningstar, a far cry from inflows of $943bn in 2021. Combined with market falls, these outflows sent total assets spinning 19.6 per cent lower to $23.9tn.
However, the far smaller, but more nascent, active ETF industry managed to attract a net $51.8bn in the same period, according to Morningstar, in line with its 2021 run rate. Even factoring in market losses, aggregate assets have still managed to tick up 1.2 per cent to $385bn.
Demand for active ETFs is holding up even better than for passive funds, with global flows into passive mutual funds and ETFs in H1, at $431bn, less than a third of 2021’s full-year tally.
“There has been a general trend away from mutual funds towards equity ETFs more broadly, and active ETFs have very much participated in that move,” said Chris Gooch, head of ETF and index sales, Emea at Citi.
Elisabeth Kashner, director of global fund analytics at FactSet, a data provider, believed that in the US, by far the largest market for active ETFs, the rise of these beasts was “structural”.
Kashner said growth had been stimulated by the “ETF rule”, introduced by the Securities and Exchange Commission in 2019, which was designed to stimulate competition in the industry by streamlining the process of bringing ETFs to market.
A second driver was the SEC’s approval the same year of non-transparent and semi-transparent structures, which allowed active managers to avoid having to disclose the full contents of their funds on a daily basis, allowing them to keep some of their “secret sauce”.
More recently still, the rise of active ETFs has been catalysed by some fund houses, such as Dimensional Fund Advisors and JPMorgan, converting existing mutual funds into ETFs.
Another factor is the adverse tax treatment mutual fund investors investing outside tax-exempt structures receive in the US — they not only have to pay capital gains tax when they exit a position but are also taxed when their fund has to sell winning positions because other investors have exited.
Due to a quirk in their structure, ETFs are immune to this latter element, although this can lead to higher tax bills when investors do sell.
Although the accelerating pace of fund conversions is an increasingly important part of the story in the US, they do not explain the full picture.
While the combined assets of active equity ETFs in the US rose by 35.5 per cent in the first six months of 2022, FactSet said, growth was still 23.1 per cent when conversions were stripped out.
“There are a lot of asset managers that have determined that the ETF is the path forward, the way of growing their business or slowing the decay of their business, so there has been a big push from the management side,” Kashner said.
However, as she pointed out, all of this explains rising supply but it “doesn’t explain why people have bought” active ETFs.
On the demand side of the equation she said Dimensional, which attracted 54.4 per cent of net flows into active ETFs targeting the broad US stock market, had “a very loyal following, especially among the adviser community”.
Dimensional also has lower fees for its ETFs than its comparable mutual funds — a common scenario, reflecting the lower cost of running an ETF — and advisers’ fiduciary duty “is to go into the lowest-cost product”.
Moreover, Kashner believed asset managers that offered both types of vehicle were increasingly “turning their marketing muscle on their ETF product”.
“[Active ETFs] are another space,” said Kenneth Lamont, senior fund analyst for passive strategies at Morningstar. “Active management has been squeezed. It’s trying to find new ways to invent itself. There is a lot of incentive and a lot of money behind finding a way to make active work.
“It’s a new marketing tool, a way to present yourself to a new audience. It’s opportunistic, it’s active managers trying to piggyback on the growth of ETFs.”
Amin Rajan, chief executive of Create Research, a think-tank, believed “a lot” of the growth was driven by institutional investors.
“They want to remain as liquid as they possibly can. At the same time, if there are any themes they want to pursue, ETFs really provide a great opportunity to capitalise on any momentum that is happening.
“Its very much part of a structural change, moving away from mutual funds,” Rajan added. “It’s happening globally, but it’s much more noticeable in the US.”
Gooch believed the trend had much further to run. “ETFs won’t completely replace mutual funds or other wrappers, such as direct indexing, but there is much further to go with active ETFs still only representing a small percentage of the overall ETF market,” he said.
The relative success of active ETFs may help asset managers’ bottom lines less than they might have hoped, however.
In the US active total equity market ETF sector, issuers whose fees averaged 0.16 per cent or less attracted three-quarters of inflows in H1, FactSet found, led by Dimensional’s cheap offerings, with those charging 0.4 per cent or more accounting for just 11 per cent of flows.
“Investor preferences for low-cost active equity ETFs show the challenge that today’s competitive landscape poses for asset managers,” Kashner said. “While differentiated strategies may launch at higher costs, competition will erode initial profit margins until the investors have captured virtually all the surplus. The only question is how long it takes.”