Active ETFs in portfolio construction
Learn more about the benefits of active ETFs in portfolio construction and reasons you may consider them.
- ETFs are a convenient investment wrapper offering advisors more solutions to manage client portfolios.
- Active ETFs offer intraday trading, potential tax efficiency, and potentially lower fees than comparable active mutual funds.
- Active ETFs can also offer the key features of active mutual funds; they may seek outperformance, offer access to niche sectors or help provide countercyclical investment strategies.
- Like traditional ETFs, active ETFs can provide core equity or fixed income exposure.
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.
Graphs exclude new funds launched in same year as capital gains distribution measurement. Equity funds analyzed were those included in the Morningstar Global Category Group. Taxable bond funds analyzed were those included in the Morningstar US Category Group.
Source: Morningstar Direct
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.
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1. Here's Why Active ETFs Are So Hot Right Now | Morningstar
2. Source: Morningstar, Fidelity as of January 29, 2024
Diversification does not ensure a profit or guarantee against a loss.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks.
In general the bond market is volatile and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer?term securities.) Fixed income securities also carry inflation, credit, and default risks for both issuers and counter parties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
*Semi-Transparent Active Equity ETFs are different from traditional ETFs. Traditional ETFs tell the public what assets they hold each day. These ETFs will not. This may create additional risks for your investment. For example: You may have to pay more money to trade the ETF's shares. These ETFs will provide less information to traders, who tend to charge more for trades when they have less information. The price you pay to buy ETF shares on an exchange may not match the value of the ETF's portfolio. The same is true when you sell shares. These price differences may be greater for these ETFs compared to other ETFs because they provide less information to traders. These additional risks may be even greater in bad or uncertain market conditions. The ETFs will publish on their website each day a "Tracking Basket" designed to help trading in shares of the ETFs. While the Tracking Basket includes some of the ETF's holdings, it is not the ETF's actual portfolio. The differences between these ETFs and other ETFs may also have advantages. By keeping certain information about the ETFs secret, these ETFs may face less risk that other traders can predict or copy their investment strategy. This may improve the ETF's performance. If other traders are able to copy or predict the ETF's investment strategy, however, this may hurt the ETF's performance.
Because shares are traded in the secondary market, a broker may charge a commission to execute a transaction in shares, and an investor may incur the cost of the spread between the price at which a dealer will buy shares and the price at which a dealer will sell shares.
Additional information for Semi-Transparent Active Equity ETFs: The objective of the actively managed ETF Tracking Basket is to construct a portfolio of stocks and representative index ETFs that tracks the daily performance of an actively managed ETF without exposing current holdings, trading activities, or internal equity research. The Tracking Basket is designed to conceal any nonpublic information about the underlying portfolio and only uses the fund's latest publicly disclosed holdings, representative ETFs, and the publicly known daily performance in its construction. You can gain access to the Tracking Basket and the Tracking Basket Weight overlap on Fidelity.com or i.fidelity.com. Although the Tracking Basket is intended to provide investors with enough information to allow for an effective arbitrage mechanism that will keep the market price of the Fund at or close to the underlying NAV per share of the Fund, there is a risk (which may increase during periods of market disruption or volatility) that market prices will vary significantly from the underlying NAV of the Fund; ETFs trading on the basis of a published Tracking Basket may trade at a wider bid/ask spread than ETFs that publish their portfolios on a daily basis, especially during periods of market disruption or volatility, and therefore may cost investors more to trade, and although the Fund seeks to benefit from keeping its portfolio information secret, market participants may attempt to use the Tracking Basket to identify a fund's trading strategy, which, if successful, could result in such market participants engaging in certain predatory trading practices that may have the potential to harm the Fund and its shareholders. Because shares are traded in the secondary market, a broker may charge a commission to execute a transaction in shares, and an investor may incur the cost of the spread between the price at which a dealer will buy shares and the price at which a dealer will sell shares.
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses.