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2024 is drawing to a close and in the world of exchange traded funds, this year will go down as one the ascent of actively managed ETFs.
That’s not bluster. Rather, it’s confirmed by data indicating that as of earlier in the fourth quarter, actively managed ETFs accounted for more than a quarter of all 2024 ETF inflows and were closing in on 10% of total assets under management. Those are data points that would have been unthinkable just 10 years ago.
It’s a safe bet that active ETFs will again be prominent in the broader ETF industry next year due to some regulatory assistance and efforts to convert more mutual funds to the ETF wrapper. Such moves have not only increased the population of actively managed ETFs, but have added more well-heeled funds to the active landscape.
Increased choice is positive for advisors and clients because it brings with it expanded asset class-level opportunities and the possibility of fee reductions over time, but that doesn’t imply selecting the right active ETFs for portfolio implementation is “easy.” It’s not necessarily difficult, but there are factors advisors should take into consideration.
With Active ETFs, Asset Class Matters
ETFs have been excellent in terms of democratizing exposure to previously hard-to-access asset classes, but that doesn’t always mean total cost of ownership is low. Due to lack of liquidity in some corners of the market, some active ETFs may be subject to wider bid/ask spreads and thus high total cost of ownership while providing access to previously hard-to-reach segments.
“ETFs built around US large-cap stocks usually don’t have these concerns,” notes Morningstar analyst Bryan Armour. “Investors should be wary of those focused on small caps, emerging-markets stocks, and sector-specific strategies. Narrowing the pool of stocks increases capacity risk and trading costs, like ETFs that only hold technology stocks or real estate.”
Multi-asset ETFs – those funds holding bonds, equities and real estate, among other assets, can be particularly vulnerable to wider spreads and high total ownership costs because it can be difficult for market makers to precisely hedge the components of a multi-asset portfolio.
“Multi-asset ETFs force market makers to hedge both stocks and bonds simultaneously, adding complexity (that is, uncertainty) to the hedging process. In fixed income, high-yield and municipal bonds trade infrequently, forcing market makers to decide whether dislocations are real or caused by a stale valuation,” adds Armour. “Market makers need a wider spread or larger dislocation to make up for these less reliable profits.”
That’s not to say actively managed multi-asset ETFs are bad ideas. Actually, active management makes a lot of sense when multiple asset classes are involved, but advisors should be aware that costs can drift higher on these products.
Methodology Matters
Finding the “best” or “perfect” actively managed ETF may be elusive, but there are some traits advisors advisors can focus on when it comes locating solid options. A big one to emphasize is finding those active ETFs that marry the perks of both active and passive investing.
“These types of ETFs can channel the benefits of passive investing in large caps and avoid the pitfalls of active ETFs in niche markets because of their diversified portfolios,” observes Armour.
Avantis and Dimensional Fund Advisors (DFA) are among the issuers whose active ETFs check those boxes.
Related: ETFs Continue to Outperform in the Capital Gains Game