Active ETFs Shine During Volatile Market Cycles

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Investors tend to associate the recent dramatic escalation in exchange-traded fund AUM with passively managed strategies. While these index-tracking products represent the bulk of the over $6 trillion in ETF assets, an influx of new actively managed products has materialized from issuers that haven’t historically offered their strategies in the ETF wrapper. Such offerings may be particularly attractive during volatile periods, given their ability to adapt to changing market environments by leveraging bottom-up security research to uncover emerging value opportunities.

Continued Growth in Assets with New Entrants
Actively managed ETFs have brought in about $51 billion in net flows year-to-date, representing roughly 15% of the total ETF inflows of $355 billion¹ this year. This is notable considering active products in this space currently comprise just 5% of all ETF assets. Furthermore, with new active entrants in this space, the industry is becoming less top-heavy and more competitive across a wider range of asset classes. Thus far in 2022, 38 new issuers are offering active products, bringing the total number of managers to 188.² Total active ETF assets have almost tripled in the past three years – with the trend anticipated to continue.

Innovation Drives Growth
A key driver of new asset growth in the active ETF space in recent months has been a flurry of conversions from mutual funds. In total, over $50B in assets have converted from mutual funds to ETFs since the first occurred in 2021. While many managers can be considered “wrapper agnostic,” converting an existing strategy to an ETF can be viewed as a means to jump-start flows. Also, with innovation of the semi-transparent structure – without the required daily actual portfolio holdings disclosure – active managers are less concerned about the risk of front-running³ and more comfortable with this wrapper. As a result, we’ve witnessed about 50 active semi-transparent ETF products come to market.

Intraday Trading, Cost-Effective Structures, Tax Efficiency, and of Course – Performance
The ETF wrapper enables active asset managers to offer their clients multiple benefits – intraday trading without minimum investment requirements, superior cost-effectiveness relative to other vehicle types, and improved tax efficiency with potentially reduced year-end capital gains distributions.

While these benefits are certainly attractive to investors, actively managed versions are ultimately judged on benchmark-relative performance. Actively managed ETFs that fall in the Morningstar US Large Blend category have outperformed the S&P 500^® Index by an average of 160 basis points YTD (as of September 30, 2022). The outperformance is even more pronounced for actively managed ETFs in the US Large Value category, delivering an average YTD excess return over the Russell 1000^® Value Index of an impressive 340 basis points, according to Morningstar.

Amid elevated market volatility, active managers are uniquely able to leverage their internal research expertise to opportunistically select only those securities with the most attractive risk/reward profiles. As passive products cannot quickly pivot to more defensive names to limit losses amid strained equity markets, they may suffer more pronounced losses than their active counterparts.

… Not to Mention Diversification
Thanks to recent market industry enthusiasm for the mega-cap technology sector, indexes such as the S&P 500^® are heavily overweight names like Apple, Microsoft, Alphabet and Amazon – leading to diminished portfolio diversification. While most actively managed ETFs take a more concentrated security selection approach than an index, managers can adjust individual holdings to control sector risk. Sophisticated factor analysis tools enable managers to further limit concentration risk to help ensure portfolios are not overly exposed to any given factor (growth, value, size, quality, momentum, etc.).

During periods of market turbulence, investors are reminded of the potential benefits of including actively managed ETFs in their portfolios. When security valuations become disjointed, as we’ve seen in 2022, investors have more choices than ever to help manage risk and position their portfolios for long-term outperformance.