Trending
Active management is experiencing a renaissance and that rebirth is attributable to an interesting source: exchange traded funds. Interesting because ETFs, which were long rooted in passive investing, were once viewed as rivals and potential death knells to actively managed mutual funds.
Some fund issuers saw the writing on the wall and today, many of the largest issuers of active ETFs are firms that trace their lineage to mutual funds. Additionally, many of the biggest active ETFs as measured by assets under management are products that were born as actively managed funds.
Advisors are big reasons why active ETFs are thriving. Active ETFs offer advisors more flexibility. ETFs don’t carry required minimum investments and, broadly speaking, they don’t close to new investors.
The rise of active ETFs is important for an array of other reasons, not the least of which the thousands of people retiring every day, boosting demand for ETFs in individual retirement accounts (IRAs), and the great wealth transfer. While baby boomers are increasingly comfortable with ETFs, they’ve long embraced actively managed mutual funds. Plus, heirs, namely Gen X and millennials, that are inheriting those assets have already been devoted fans of ETFs – active and passive.
Let’s explore more catalysts behind the rise of actively managed ETFs.
Fixed Income Fabulous for Active ETFs
Broadly speaking, data confirm that active managers have trailed their benchmarks across various asset classes in recent years. However, there are examples of asset classes where active managers can and do shine. Those include bonds.
“One reason for the early success of active management for fixed income ETFs may be that the traditional approach to passive investing—holding each security at approximately the same proportions as an ETF’s underlying index—is quite rare for passive fixed-income ETFs, accounting for just 5% of assets,” according to First Trust. “Instead, most passive fixed-income ETFs seek to match the risk and return characteristics of a given benchmark by investing in a sample of its underlying securities. While there are practical reasons for this approach when it comes to fixed income, we believe sampling involves a series of active decisions about which individual securities to hold or avoid, which can sometimes result in undesired tracking error.”
In terms of aggregate bond strategies, active’s five-year performance advantage over passive is negligible, but when delving into some individual fixed income segments, active’s advantages over passive become apparent.
As noted by First Trust, actively managed fixed income ETFs addressing corners of the bond market such as banks loans, local currency emerging markets bonds, preferred stocks and rate hedging have outpaced passive rivals by wide margins.
Bond Ballast for Active Management
Yes, data confirm that active managers take their lumps when it comes to equities. There’s no denying that stock-picking is a tricky endeavor and it’s unlikely equity-based active ETFs will usurp their passive rivals in terms of advisor preference/assets under management.
However, the combination of active management, ETFs and fixed income is potent. Plus, it can reduce risk and potentially improve outcomes for clients.
“For example, while managing credit risk may be beneficial for most fixed-income categories, we believe it’s essential for those that focus on securities issued by below investment-grade borrowers, such as bank loan funds (a.k.a., senior loan funds) or high-yield bond funds,” concludes First Trust. “Similarly, while interest rate risk is a key driver of fixed-income returns in general, active managers in the preferred stock category may have added flexibility to address this risk, by increasing or decreasing exposure to fixed-rate, floating-rate, or fixed-to-floating rate securities. In our opinion, the ability to manage various dimensions of risk has been a key differentiator for active ETFs.”