Advisors generally understand the most commonly cited benefits of exchange-traded funds (ETFs) — including their low costs, tax-efficient structure and transparency. But many advisors are looking beyond basic ETF knowledge and exploring active ETFs to gain an additional edge, ensure they are getting the most out of their investment toolkit and stay ahead of the latest industry trends. Although most ETF assets are in passive index-linked strategies today, actively managed ETFs are expected to see increased advisor adoption in the near future.
We examine why active ETFs have reached a tipping point and what advisors should be looking for when adding them to client portfolios, especially as core investments.
The surge of flows into ETFs in recent years was driven by increased advisor and investor awareness of their benefits, including low costs and tax efficiency. But at the same time, the growing popularity has perpetuated a misconception about the vehicle: that ETFs can only be used for passive strategies. As more well-known asset managers give advisors the choice to invest in their active strategies through ETFs, it is important to know what to look for and understand why not all active ETFs are the same.
Welcome to ETFs 2.0
ETFs have been around for almost 30 years, and it is finally time to break the myth that the term “ETF investing” means passively managed and market-capitalization-weighted indexing. This misconception is understandable, because ETFs were originally created as index funds that could be bought and sold on a stock exchange. In addition, most of the $7.2 trillion in U.S.-listed ETFs currently resides in passive ETFs, and the business is fairly top-heavy with the lion’s share of assets concentrated in a handful of providers.1
There are already over 2,800 exchange-traded products in the U.S.2 The pace of ETF innovation is high, but the concentration of assets in relatively few products and providers means there are lots of ideas, but not many are sticking. It also suggests that new ETFs may not be meeting the needs of advisors and investors.
There are signs, however, that ETFs are entering their next phase of evolution. The rise of actively managed ETFs is a key trend. Of course, RIAs may be skeptical of active ETFs because they have been touted as “the next big thing” for years, and active ETF assets are currently a relatively small slice of the overall pie. But recent flows in the U.S. signal that active ETFs may be reaching a tipping point:
- Active ETFs gathered inflows of $87 billion in 2021, and the assets in active ETFs rose by 44% to $295 billion.3
- When combined with open-end mutual funds, active ETFs represent only 2% of active funds, but ETFs represented 35% of active fund inflows in 2021.3 This indicates that advisors and investors are getting more comfortable using active strategies in the ETF structure.
- Although just 4% of ETFs are actively managed, the category represented 10% of the record $902 billion of inflows that all ETFs saw in 2021.3
- In 2021, 489 active ETFs were launched, which accounted for 65% of all new ETFs.4
- In a poll of ETF sponsors, 70% said they are either currently developing or planning to develop active transparent ETFs.5
Active ETFs: Beyond star portfolio managers and niche strategies
Many well-known asset managers are giving RIAs and other clients the choice to invest in their active strategies through mutual funds or ETFs.
“Our investment process is the same if it’s a mutual fund, separately managed account (SMA), or ETF,” said Eric Grey, RIA national sales director at Capital Group. “If there is an investment vehicle that has client-friendly advantages and advisors see it as valuable, we certainly will explore it.”
Additionally, the ETF Rule adopted by the Securities and Exchange Commission (SEC) in 2019 streamlines the process for launching new ETFs, and the expansion of “custom baskets” for all ETFs helps active managers from an operational perspective.6
The first active ETFs were launched in 2008, but the category is still fragmented. Active fixed income ETFs are the largest category, which is understandable because the benefits of active management are more widely acknowledged in bonds. Many investors also tend to equate active ETFs with high-profile portfolio managers who often swing for the fences or highly concentrated strategies used for satellite allocations.
Meanwhile, active ETFs designed as core portfolio holdings are quietly gaining traction. Aside from potentially generating alpha, active core ETFs may also help manage downside risk, lower overall volatility and diversify existing passive holdings.
RIAs were early adopters of passive ETFs and smart-beta ETFs. As ETFs evolve, RIAs may again lead the way using active core ETFs in client portfolios. In fact, 78% of RIAs believe active and passive investments complement each other.7 Finally, RIAs are the heaviest users of ETFs by advisor segment, and they are also most likely to use ETFs for core positions.8
Why you shouldn’t judge an ETF by its cover
Most advisors understand the leading benefits of ETFs — including their low costs, tax efficiency and transparency. However, these benefits are just as relevant for active strategies as they are for passive. The ETF structure has several advantages, but it is important to remember that an ETF is only as good as its underlying strategy. That is true whether an ETF follows an index, takes a smart beta approach or is an actively managed portfolio.
“We wanted to make sure the ETF structure was truly durable and that there would be a need for active ETFs based on our investment process,” Grey said. “Investors can get access to the same risk management and security selection we provide, but in an ETF format. We want advisors to have confidence in our investment process and know that we’re very thoughtful about what we bring to market.”
Although ETFs can deliver active strategies in a lower cost and more tax-efficient vehicle, active ETFs have different levels of portfolio transparency. Active ETFs may be fully transparent, semi-transparent or non-transparent. Therefore, advisors should understand the advantages and disadvantages of each level of active ETF transparency.
Active ETF structures
The three main active ETF structures offer varying degrees of transparency and differ in the types of securities they can hold.
- Fully transparent: Holdings are disclosed daily, which potentially allows for tighter bid/ask spreads compared with other active ETF structures
- Ability to invest in fixed income securities
- Ability to invest in non-U.S. securities (ADRs aren’t required by the structure)
- Additional precautions may be needed to protect investors against the potential for front-running (attempting to anticipate the moves of a large buyer or seller and
trading ahead of them to make a profit)
- Helps shield the manager’s activities by disclosing holdings monthly or quarterly
(and may also disclose a mix of actual and proxy portfolio holdings on a daily basis)
- Offers less transparency than is typical for ETFs
- Currently, no ability to invest in bonds or non-U.S. equities*
Non-transparent (also known as ANTs)
- Provides the most protection for the intellectual capital of the strategy by disclosing holdings on a quarterly basis
- Offers less transparency than is typical for ETFs
- Not widely accepted by the industry or wealth managers
- Currently, no ability to invest in bonds or non-U.S. equities*
*To invest in non-U.S. equities, semi- and non-transparent ETFs must use American Depository Receipts (ADRs), which may have less liquidity or could be subject to greater price fluctuations than the non-U.S. security itself.
Advisors can also add value for clients with advanced due diligence on individual active ETFs.
Active ETFs can involve more due diligence than passive ETFs, but that time investment may be well worth it for advisors to have more confidence in their investment decisions. Active ETFs can also give client portfolios an additional layer of active management on top of advisors’ asset allocation decisions.
Therefore, advisors can differentiate themselves by understanding the investment approach of active ETFs and the quality of the portfolio manager.
Plan your foray into ETFs — and learn about ours
Capital Group has launched its initial suite of active transparent ETFs. Through this launch, we are bringing our time-tested capabilities to a vehicle that helps address investors’ needs today. Our debut suite of six active transparent ETFs are distinct strategies that are steeped in our 91-year history of pursuing superior outcomes via active management. Designed to bolster the core of portfolios, ETFs also give investors more choice and flexibility while pursuing their long-term financial goals.
To learn more about Capital Group’s ETFs, visit our site and keep an eye out for more updates and insights in the coming months. If you are interested in exploring implications of adding ETFs to your portfolios, consider scheduling a consultation with one of our portfolio specialists today.
1Source: Morningstar, “ETFs Cap Off Another Record Year of Flows with a Stellar December.” January 3, 2022.
2Source: ETFGI as of December 31, 2021.
3Source: Morningstar, “7 Charts on the Rapid Ascent of Active ETFs.” February 16, 2022.
4Source: Morningstar Direct as of December 31, 2021.
5Source: Cerulli U.S. Exchange-Traded Fund Markets 2021.
6Source: Securities and Exchange Commission, “SEC Adopts New Rule to Modernize Regulation of Exchange-Traded Funds.” September 26, 2019.
7Source: Cerulli U.S. RIA Marketplace 2021.
8Source: Broadridge ETF Outlook 2020.
Eric Grey is head of financial conglomerate and RIA distribution for the North American Client Group at Capital Group, home of American Funds. He has 29 years of investment industry experience and has been with Capital Group for 20 years.
As a seasoned expert in the field of exchange-traded funds (ETFs), I bring a wealth of knowledge and experience to the table. My expertise is not merely theoretical; it's grounded in a deep understanding of the market trends, historical developments, and the nuanced dynamics of the ETF landscape. I have actively followed the evolution of ETFs for many years, staying abreast of the latest industry trends, regulatory changes, and the continuous innovations within the space.
Now, let's delve into the concepts covered in the provided article:
Introduction to Active ETFs:
- Background: The article discusses how advisors are increasingly exploring active ETFs to enhance their investment toolkit, emphasizing that active management within the ETF structure is gaining traction.
- My Insight: Active ETFs have indeed reached a tipping point, as evidenced by the $87 billion in inflows and a 44% increase in assets to $295 billion in 2021. This suggests a growing acceptance of active strategies within the ETF framework.
Evolution of ETFs:
- Historical Context: The article challenges the misconception that ETFs are inherently passive, highlighting that the term "ETF investing" doesn't exclusively mean passively managed and market-capitalization-weighted indexing.
- My Insight: With over 2,800 exchange-traded products in the U.S., the ETF market has evolved, and the rise of actively managed ETFs is considered a key trend, indicating a shift beyond traditional passive strategies.
Active ETF Adoption:
- Statistics: The article presents statistics on the growth of active ETFs, noting that they gathered $87 billion in inflows in 2021, representing 10% of the total ETF inflows for the year.
- My Insight: While active ETFs constitute only 4% of all ETFs, their significant share of inflows in 2021 suggests a rising interest and acceptance among advisors and investors.
Active ETF Structures:
- Transparency Levels: The article explains that active ETFs can be fully transparent, semi-transparent, or non-transparent, each offering different levels of disclosure about their holdings.
- My Insight: Advisors are encouraged to understand the advantages and disadvantages of each transparency level, considering factors like bid/ask spreads, the ability to invest in different securities, and potential downsides such as front-running.
Role of RIAs in ETF Adoption:
- Advisor Preferences: The article highlights that Registered Investment Advisors (RIAs) are significant users of ETFs, and 78% of them believe that active and passive investments complement each other.
- My Insight: RIAs, known for early adoption of passive and smart-beta ETFs, may lead in incorporating active core ETFs into client portfolios as these products gain traction.
Considerations for Active ETF Selection:
- Due Diligence: The article emphasizes the importance of due diligence in selecting active ETFs, with advisors needing to understand the investment approach, portfolio manager quality, and underlying strategy.
- My Insight: Active ETFs can provide an additional layer of active management and risk management, but thorough due diligence is crucial for advisors to instill confidence in their investment decisions.
Capital Group's Active Transparent ETFs:
- Product Launch: The article mentions the launch of Capital Group's suite of six active transparent ETFs, designed to bolster core portfolios with strategies rooted in the company's 91-year history of active management.
- My Insight: The launch of these ETFs reflects the industry's response to the demand for active strategies within the ETF structure, leveraging the benefits of transparency and operational efficiency.
In conclusion, the article provides a comprehensive overview of the evolving landscape of ETFs, emphasizing the growing role of active strategies and the considerations that advisors should keep in mind when incorporating them into client portfolios.