The rapid, record rise of active equity ETFs amid market volatility

Key Concepts:

• Active ETFs: Exchange-Traded Funds that are actively managed by a portfolio manager or a team of managers, as opposed to passively tracking an index.
• Passive ETFs: ETFs that track a specific market index, such as the S&P 500, and aim to replicate its performance.
• Assets Under Management (AUM): The total market value of the investments that a financial institution manages on behalf of its clients.
• Systematic Strategies: Investment strategies that rely on rules-based or quantitative models to make investment decisions.
• Factor Tilts: Investment strategies that overweight or underweight specific factors, such as value, growth, or small-cap stocks, in order to achieve a desired investment outcome.
• Options-Based Income ETFs: ETFs that generate income by selling options contracts on the underlying assets in the portfolio.
• Buffer ETFs: ETFs that provide a buffer against market declines by using options strategies to limit potential losses.
• Active Share: A measure of how much a portfolio's holdings differ from its benchmark index.
• Closet Indexing: A situation where an actively managed fund closely resembles a passive index fund, but charges higher fees.
• Leveraged ETFs: ETFs that use financial leverage to amplify the returns of the underlying index or asset.

1. Rise of Active ETFs and Market Volatility

• Active ETFs have surpassed $1 trillion in assets under management (AUM) for the first time, representing almost 10% of total ETF assets.
• 30% of ETF inflows this year have been into active funds, marking another record.
• The rise in active ETFs correlates with market volatility and unprecedented concentration in equity markets, where the 10 largest stocks constitute a significant portion of the index.
• Investors seek differentiated exposure and downside protection amid market uncertainty.

2. Types of Active ETFs and Their Strategies

• The bulk of inflows are going into systematic strategies from issuers like Dimensional, JP Morgan, and Avantis, which are lower cost and rules-based.
• These strategies often involve factor tilts, such as value, growth, small-cap, or big-cap, to influence portfolio characteristics.
• Options-based income ETFs, like JPM's JEPI, generate income by managing an option sleeve on a portfolio of stocks selected based on low volatility and quality.
• Buffer ETFs provide downside protection by using options strategies to limit potential losses, appealing to investors seeking to preserve their nest egg.

3. The Shift Away from Old-School Stock Picking

• The current trend in active ETFs differs from the old-school stock-picking approach seen in 2020 with innovation and disruption funds.
• Investors are no longer willing to pay high fees for closet indexing, where actively managed funds closely resemble passive index funds.
• Active managers must either offer low fees or provide high active share, meaning their portfolios must differ significantly from the benchmark.

4. The Role of Demographics and Investor Needs

• Buffer ETFs cater to demographics like baby boomers who want equity exposure with downside protection to avoid significant losses.
• Investors are seeking income generation and downside protection in response to market conditions and life stage needs.

5. Cost Considerations and Fee Structures

• Dimensional and Avantis offer indexing-plus strategies at low costs, around 20 basis points, making them competitive.
• The industry has a natural tendency to expand into new products to charge higher fees, especially in exotic active strategies like leveraged ETFs.
• Leveraged ETFs, which amplify returns using leverage, can charge higher fees, such as 90 basis points, due to their complexity and risk.

6. Single Stock ETFs

• The rise of active ETFs also includes the emergence of around 100 single stock ETFs, offering focused exposure to individual companies.

7. Notable Quotes and Attributions

• "The days of investors paying up for closet indexing, those are over."
• Active managers either need to be cheap or they need to have high active share.

8. Logical Connections and Synthesis

• The rise of active ETFs is driven by a combination of market volatility, investor demand for differentiated strategies, and the need for income and downside protection.
• The shift away from old-school stock picking towards systematic and factor-based approaches reflects a focus on cost-effectiveness and risk management.
• The ETF industry is expanding into new product categories, such as leveraged and single stock ETFs, to cater to diverse investor needs and fee structures.

9. Conclusion

The active ETF landscape is evolving, with a focus on low-cost, systematic strategies and specialized products like options-based income and buffer ETFs. Investors are increasingly demanding value for their money, driving a shift away from closet indexing and towards active management that offers either lower fees or significantly different exposures than traditional benchmarks. The expansion into leveraged and single stock ETFs represents a further diversification of the active ETF market.