Actively-managed exchange-traded funds have become increasingly popular over the past year. According to FactSet Research, active ETFs took in $83 billion, or 17%, of net flows during the first half of the year, despite holding just 3% of all ETF assets. These trends will likely continue into next year, particularly as active mutual funds transition to ETFs.
There’s no shortage of marketing literature touting the benefits of active ETFs, and there are many corners of the market where active strategies make a lot of sense, such as fixed income. On the other hand, many investors already know that active ETFs tend to have higher expense ratios than their passive counterparts.
Let’s take a look at some other active ETF drawbacks that investors should keep in mind.
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Why Invest in Active ETFs?
Active ETFs have become tremendously popular due to their lower costs and greater liquidity. Most ETFs charge a set expense ratio—a welcome change from the laundry list of mutual fund expenses—and trade on a conventional stock exchange, like the NASDAQ or NYSE. This makes them a lot more palatable and easier to trade than mutual funds.
In addition, ETFs are a lot more tax-efficient than mutual funds. Mutual funds incur several costs to facilitate redemption requests, and these costs are spread out amongst all shareholders. On the other hand, ETFs use a creation and redemption mechanism that offloads a lot of the cost to investors buying and selling ETF shares, not long-term holders.
In 2019, the SEC’s ETF Rule expanded the potential tax benefits by allowing issuers to tailor their creation and redemption baskets. These dynamics help managers add and remove securities more selectively from ETF portfolios and improve their tax efficiency. The result is an even better relative benefit from a tax standpoint.
Fewer Opportunities
Active managers seek out opportunities by looking at everything from macroeconomic trends to individual security valuations. While hedge funds are the most versatile investment vehicle, mutual funds can participate in most long-term opportunities. For instance, the Fidelity Contrafund (FCNTX) famously owns stakes in unlisted startups.
On the other hand, private companies are off-limits to ETFs. In addition, nontransparent active ETFs can only invest in securities that trade during the same market hours as the funds themselves. These funds can hold ADRs and other ETFs but may not own foreign securities that trade on overseas exchanges (potentially at a better value).
Fewer opportunities could translate to lackluster returns. For instance, tech-focused active mutual funds could participate in startup fundraising. In contrast, tech-focused active ETFs could only purchase tech companies that have already gone public, typically at the later end of their growth curve. There are also fewer international opportunities.
Unique Growing Pains
Most active ETFs focus on large-cap equities and short-term fixed income, whereas active mutual funds focus on just about every corner of the market. That’s because ETFs cannot refuse new investments—they must find a place for every dollar. That’s problematic for managers looking to maximize returns in smaller niche markets.
These problems have already surfaced in some large passive ETFs. For instance, the VanEck Vectors Junior Gold Miners ETF (GDXJ) had to buy stocks beyond its benchmark index to avoid acquiring a 20%+ stake in some index constituents, triggering a takeover offer request under Canadian rules. As a result, the fund deviated from its intended strategy.
Active ETF managers may face a similar challenge: maintaining their strategy and hitting performance goals with constantly growing assets under management. Unfortunately, without the ability to close their funds, they could end up purchasing their next-best ideas or adding to existing positions at less compelling valuations.
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The Bottom Line
Actively-managed ETFs have become increasingly popular over the past couple of years. While they offer a lot of well-known advantages, investors shouldn’t neglect the drawbacks. Most are familiar with the higher expense ratios, but capacity concerns and limited investment opportunities may surprise many investors.
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