ETF Edge: Active ETFs overtake $1 trillion milestone

ETF Edge: Active ETFs and Dual Share Class Structures

Key Concepts:

• Active ETFs: Exchange Traded Funds that are actively managed, aiming to outperform a specific benchmark index.
• Passive ETFs: ETFs that track a specific index and aim to replicate its performance.
• Factor Tilts: Investment strategies that emphasize specific factors (e.g., value, growth, small-cap) to achieve desired investment outcomes.
• Options-Based Income ETFs: ETFs that generate income by selling options contracts on underlying assets.
• Buffer ETFs: ETFs designed to provide downside protection by limiting potential losses in exchange for capped upside potential.
• Ultra-Short Bond Funds: Actively managed fixed income funds that invest in very short-term debt securities.
• Dual Share Class Structure: A proposed structure that allows the same investment portfolio to be offered as both a mutual fund and an ETF.
• Active Share: A measure of how different a portfolio is from its benchmark index.
• Closet Indexing: The practice of an active manager constructing a portfolio that closely resembles a benchmark index while charging higher fees.

Rise of Active ETFs

• Active ETFs have surpassed $1 trillion in assets under management (AUM), representing almost 10% of total ETF assets.
• 30% of ETF inflows this year have been into active funds, marking a record.
• The bulk of flows are going into systematic strategies (Dimensional, JP Morgan, Avantis) rather than traditional stock-picking active managers.
• Volatility in the market has correlated with the rise in active ETFs.
• Unprecedented concentration in equities (top 10 stocks comprising 40% of the index) drives demand for active management to water down concentration.
• Rate normalization and the end of quantitative easing (QE) have made active management in fixed income more appealing.

Types of Active ETFs and Their Drivers

• Factor Tilts (Dimensional, Avantis): Low-cost, rules-based strategies that offer differentiated exposure by tilting towards specific factors like value or small-cap. These are less "career risky" for financial advisors.
• Income Generation (JPMorgan Equity Premium Income ETF - JEPI): ETFs that generate income through strategies like selling covered calls.
• Downside Protection (Buffer ETFs): ETFs that offer a buffer against market declines, appealing to investors seeking to protect their nest egg, especially in volatile environments.
• Ultra-Short Bond Funds: Active fixed income funds attracting inflows due to attractive yields (around 5%) and uncertainty in the rate environment.

Active vs. Passive Management and Fees

• Investors are no longer willing to pay high fees for "closet indexing."
• Active managers must either be low-cost or offer high active share to justify their fees.
• The growth of active ETFs is driven by the expansion of product offerings and the ability to charge higher fees than passive funds.
• Exotic active strategies, such as leveraged ETFs, can justify higher fees (e.g., 90 basis points).

Active Fixed Income

• Active fixed income managers have a better performance track record than their equity counterparts, making them more appealing to financial advisors.
• The Bloomberg Aggregate Bond Index is flawed as a benchmark because it lacks high yield, asset-backed securities, and mortgage-backed securities.
• Active managers can outperform by strategically managing duration risk and investing in securities with low duration and good interest.

Tax Efficiency of ETFs

• ETFs are a more tax-efficient wrapper for active management than mutual funds.
• ETFs are typically lower cost and more tax-efficient than mutual funds, lowering the bar for active managers to generate alpha.
• The biggest names in asset management are now offering their flagship strategies in ETF wrappers.

Dual Share Class Structure

• The SEC is considering dual share class listings, allowing the same portfolio to be offered as both a mutual fund and an ETF.
• This structure reduces taxable events and lowers back-end costs for issuers.
• It allows asset managers to maintain their lucrative 401k business while pursuing growth in the ETF market.
• The dual share class structure could slow the conversion of mutual funds to ETFs.
• Approximately 50 firms have applied for this structure.
• The industry generally expects approval before the end of the year.
• Operational infrastructure needs to be established to execute this structure.
• The SEC has expressed concerns about cross-subsidization, where costs in the mutual fund could impact ETF shareholders.

Notable Quotes:

• "The days of investors paying up for closet indexing, those are over."
• "Money goes where it's treated best and the results are clear in terms of ETFs versus mutual funds."

Synthesis/Conclusion:

The active ETF market is experiencing significant growth, driven by factors such as market volatility, demand for differentiated exposures, and the tax efficiency of the ETF wrapper. Investors are increasingly seeking active strategies that offer either low costs or high active share. The potential approval of dual share class structures could further accelerate the growth of active ETFs by allowing asset managers to offer the same portfolio in both mutual fund and ETF formats. While there are some potential concerns regarding cross-subsidization, the overall sentiment is that this development would be a win for investors.