The woes of active management across both stocks and bonds are well-documented, but hope burns eternal for active to get its act together against passive.
One avenue for active managers – and they’re seizing it – to cobble together momentum is the mutual fund-to-ETF conversion. It’s something of a “if you can’t beat ‘em, join ‘em” proposition, but it’s one that’s increasingly common in the fund industry and an option being embraced by some of the biggest names in active management.
In 2019, the SEC approved Rule 6c-11, colloquially known as the “ETF Rule.” That set the stage for active mutual funds to be efficiently converted to ETFs. Yes, these products remain actively managed, but by becoming ETFs, the funds and their investors can enjoy critical benefits such as superior tax treatment and, potentially, lower fees.
Those are important perks and when coupled with a more democratized regulatory process, could pave the way for more mutual funds becoming ETFs.
Inside the Shift
Data confirm that momentum is building for active ETFs and that pertains to both the funds that were born as ETFs and those that started life as actively managed mutual funds.
“The menu of active ETFs that reached $1 billion in AUM continues to expand. By the end of 2022, 62 had reached that mark, and the current list features a more diverse range of strategies than it did in 2017,” observes Morningstar’s Bryan Armour. “The 62 ETFs from 21 different providers were split almost evenly between equity and fixed-income strategies, with a couple of commodities ETFs sprinkled in.”
As noted above, costs matter. While active mutual fund fees have trended lower in recent years due in large part to passive ETFs continually stealing market share, the same is true of passive ETFs. In fact, passive ETFs are widely synonymous with low costs. While active ETFs aren’t guaranteed to have low fees, the ETF wrapper makes it easier to get there and that’s meaningful to advisors and clients alike.
“Our research shows that low fees are a good predictor of success. Furthermore, the most recent Morningstar Active/Passive Barometer found that the cheapest decile of active funds posted success rates 13 percentage points higher than the most expensive quintile,” adds Armour. “In fact, we found that success rates were higher for cheaper funds in 14 of 15 stock Morningstar Categories (the lone exception had the same success rate between the cheapest and most expensive funds).”
Active ETFs Not Perfect, But…
An active manager’s ability to deliver for investors will be tested or shine regardless of fund structure. That is to say active ETFs aren’t perfect. Indeed, there are some issues for advisors to discuss with clients.
“Active ETF investors would be wise to invest in strategies that maintain their edge when assets balloon. At a minimum, investors should periodically monitor their ETF’s AUM, especially when investing in more-niche strategies, concludes Armour. “Concentrated strategies in young industries may not have a lot of investment opportunities that align with a fund’s objective. And too much money chasing after a limited number of companies can create asset bubbles that will eventually pop when they become highly popular. In other words, you don’t want the money flowing into an ETF to heavily affect the valuation of its holdings.”
Bottom line: Active ETFs aren’t perfect and the ability of managers will be tested here, but there’s no denying the structure is appealing. Apparently, plenty of mutual fund issuers agree.
Related: Golden Retirement Planning Ideas, Insights with GSAM