Unlocking the potential of active ETFs: four reasons to invest now

Perhaps one of the hottest trends in investing is the rise of active exchange-traded funds (ETFs). Thanks to several rule changes in 2019, the growth of active ETFs has been rapid. Assets under management in active ETF products have increased 20% annually since the rule change. Today, there are nearly 1,500 active ETFs holding over $668 billion in assets.

And yet adoption rates are still slow.

Many investors and advisors have yet to pull the trigger on using active ETFs in their portfolios, which is a shame because the fund vehicle can provide many benefits and help portfolios achieve their goals. With that in mind, for investors who are hesitant to use active ETFs in their portfolios, here are four big reasons to consider them for your investments.

A Brief History of Active ETFs

Believe it or not, active ETFs have long been available to investors. The first was launched in 2008. But it wasn’t until just before the pandemic that active ETFs took off significantly. The reason was due to a series of rule changes from the SEC.

Because ETFs rely on market makers for intraday liquidity and to keep their stock prices tied to their net asset value, managers are required to disclose their holdings daily, which is generally not a big deal for an ETF. index fund. We can easily find out what’s inside the S&P 500 or the Dow Jones Industrials. But for active management – ​​which can hold anything, in any proportion – this can lead to a race to the front.

Changes at the SEC have allowed managers to have different levels of transparency regarding their holdings. Different solutions have been developed to provide market makers with the information they need without disclosing the underlying holdings. Thus, active ETFs have grown considerably. This chart from Morningstar shows the growth of active ETFs after the 2019 change.

However, not everyone uses them. Mutual funds may be partly to blame. Active mutual funds have historically significantly underperformed index funds. This stain could have been unfairly attributed to the world of active ETFs. The fact is that active ETFs solve many of the problems with mutual funds, and their use could have four major advantages.

1. Tax efficiency

Uncle Sam always seems to have an open hand when it comes to investing, and portfolios pay a whole host of different taxes on their earnings, dividends and interest income. Overall, you can control taxes. But for investors who hold mutual funds, they are at the mercy of portfolio managers and other fund holders.

The problem is that investors have to pay taxes based on what happens within a mutual fund. If an active manager sells a stock or bond – even if an investor does not sell his or her shares in the fund – he or she suffers a capital gains distribution and is obligated to pay the tax. The tax brake can have a significant impact on long-term returns. After all, what you keep is just as important as what you make.

Active ETFs are different. It depends on their structure and their creation/redemption mechanism. You and I buy ETFs on the secondary market of exchanges. However, ETFs use what are called authorized participants (APs) to create and redeem shares. These APs are willing to take shares of a security when they redeem their ETF shares. This allows active managers to pass on the ETF’s gains and avoid capital gains tax. Secondary market investors only pay taxes on gains when they decide to sell the shares.

2. Low costs

One of the benefits that holders of passive and index ETFs have enjoyed is the lower costs associated with managing an ETF compared to a mutual fund. Today, you can get index funds that cost less than 0.05% in fees. It turns out that this also works for active funds and gives an extra boost.

By removing all fees, most active managers actually manage to beat their benchmarks. However, fees and expenses create a so-called hurdle that managers must clear to show this outperformance. If you beat your benchmark by 0.50% per year but charge 0.65% to do so, investors will underperform.

The advantage is that active ETFs charge much lower fees than active mutual funds. Today, investors can purchase active ETFs for as little as 0.15% in expenses. It’s cheaper than some index funds. With lower fees, active managers can deliver on their promises of better returns. Investors can therefore really achieve outperformance.

3. Transparency

While changes to SEC rules, which allowed the creation of new non- and semi-transparent structures, could have been the starting point for the active growth of ETFs, it turns out that most active ETFs have adopted transparent structures. In fact, it’s an overwhelming majority. The number of semi-transparent ETFs in the market is less than 100 funds.

This gives active ETFs an advantage over mutual funds without hurting performance. Mutual funds are only required to report their holdings on a quarterly basis. But with active ETFs, investors know exactly what they own each day. Second, front running issues don’t seem to be a problem and performance hasn’t been hampered.

4. Liquidity and flexibility

Finally, active ETFs offer a level of liquidity and flexibility that mutual funds cannot achieve.

Like passive ETFs, active ETFs can be traded throughout the day. This contrasts with mutual funds, which can only be bought and sold at end-of-day net asset values. It also allows investors to use active ETFs to take advantage of down periods to buy or tax lost crops and plan their spending needs, giving them a liquidity advantage over mutual funds. Additionally, investors have the ability to sell short, pledge ETFs in securities lending programs, and trade options on active ETFs. Finally, active ETFs can be used as collateral for margined portfolios. Not all mutual funds will be eligible at all brokerage firms.

Play an active ETF

Overall, active ETFs offer the best of both worlds. Investors have a chance to outperform while enjoying the many benefits of passive ETFs. With less tax potential and less flexibility, using them in a portfolio quickly becomes obvious.

And with new funds launching almost every month, investors have plenty of options for incorporating them into their portfolios. As with all investments, it is essential to review the holdings and fees to ensure you are purchasing the right fund.

Popular active ETFs

These ETFs are sorted by their year-to-date total returns, which range from -2.7% to 7.8%. They have expense ratios between 0.17% and 0.36% and assets under management between $5 billion and $30 billion. They currently yield between 0.8% and 9.7%.

Ticker Name AUM YTD Total Ret (%) Yield (%) Exp Ratio Title type Actively managed?

Conclusion

The growth of active ETFs has been rapid. For investors who are still hesitant to use them, the liquidity of active ETFs, their low costs and their tax savings are wonderful advantages that mutual funds cannot touch. Given the potential for outperformance, investors should opt for active ETFs in their portfolios.

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