Portfolio construction and allocation is a tough nut to crack. Getting the right grouping of asset classes and funds together can take plenty of skill. Exchange traded funds (ETFs) have made that job a bit easier. With the daily tradable baskets of stocks, bonds, and other asset classes, investors can quickly and easily build a portfolio to suit their needs.
And for those in retirement, choosing active ETFs could be their best bet.
It turns out that active management can provide some very unique benefits for retired investors and ETFs are the perfect structure for getting the most out of these rewards. By selecting some active management for their portfolios, retired investors can have their cake and eat it too.
The Rise of Active ETFs
The first active ETF came to market in 2008, but it wasn’t until 2021 that active ETFs took off. Driven by new rule and changes regarding transparency, the number of actively managed funds has blossomed over the last few years. Today, there are nearly 1,400 active ETFs on the market with more than $600 billion in assets.
That’s a huge leap forward for the investment vehicle. However, it’s still a far cry less than what has been placed inside of passive or index ETFs.
Part of the reason for the lack of adoption has to do with the perception that active underperforms passive management. That’s true… when it comes to mutual funds. Index funds have long beaten many active mutual funds. However, ETFs—and many of their structural benefits—have turned the page in that book.
And it turns out many of those benefits make active ETFs perfect for those near or in retirement.
Four Big Reasons
For investors near or in retirement, balancing growth, income, and tax savings are key pieces of the puzzle when it comes to asset allocation. Investors don’t have the long timelines of a worker just getting started. Moreover, the return of principal may be more important than the return on principal.
And luckily, active ETFs can solve many of the issues facing retired investors.
Tax Savings
Taxes are arguably one of the most daunting issues facing investors in retirement. Capital gains, interest income, dividends, etc. all need to be paid to Uncle Sam. The issue for active mutual funds is that investors aren’t in control of when those taxes are paid.
Thanks to their structure, buy & sell decisions within the mutual fund result in capital gains that are paid out to all shareholders of the fund, on which taxes are due. Those taxes are owed even if an investor doesn’t sell their shares. To make matters worse, investors will be on the hook for gains taxes when they finally sell their shares.
However, ETFs via their creation/redemption mechanism prevent the first kind of capital gains for investors. Authorized participants can and do accept underlying assets when redeeming their shares, which prevents capital gains. Investors generally only pay taxes when they choose to sell their shares. For active management, this is critical considering they have much higher turnover rates than passive funds.
Lower Volatility
That higher turnover rate and the ability to buy/sell has another benefit for retired investors: lower volatility. Passive funds are wonderful in that they own everything and remain fully invested. This is great during rising bull markets. But when the tide turns, they drop.
The sequence of withdrawal risk occurs when those starting their retirement during a bear market. Losses are locked in and the risk of running out of money grows.
However, because managers of active funds don’t have to act like index funds, they can sell their holdings at will. This allows them to flee to cash or buy safer stocks or bonds. This can reduce volatility and losses for an active fund during a bear market. Data backs this up. During 2022’s bear market and wide losses for the all-asset classes, the S&P Global SPIVA U.S. Scorecard—which compares active to passive funds—showed that active managers were able to beat their passive benchmarks by a wide margin and incurred fewer losses across a variety of different asset classes and subclasses. 1
Better Returns in Key Income Asset Classes
Speaking of those asset classes and various sub-asset classes, active management may have an edge for retired investors: better returns.
Income is a huge component of many retired investors’ portfolios and that means bonds are often front and center. And it turns out that active management can play a huge role in generating extra income and returns in various bond sectors.
That’s because the major bond indexes are poorly constructed. Often, they weigh their holdings based on the amount of debt outstanding. This means the biggest debtors have more assets. Second, many bond indexes exclude whole swaths of their universes.
Active bond managers don’t have to look like an index. This means they can perform credit analysis, buy values or higher-yielding bonds, and change durations/maturities to match their outlooks. This can add extra yield and income to a portfolio as well as boost total returns. When you’re drawing off your assets to create a paycheck, every percentage point counts. Active ETFs can deliver.
Lower Costs
Finally, active ETFs are able to deliver all of this with much lower costs than active mutual funds. Today, there are many active ETFs that charge less than passive funds. The less you pay in fees, the more you get to keep. Numerous studies have shown these fee hurdles are the reason why active mutual funds have underperformed.
A Great Choice for Retired Investors
With lower taxes, lower volatility, and the chance for greater income and outperformance, active ETFs should be on every retired investor’s radar. And, most importantly, they can help drive returns on a variety of fronts while saving on fees/costs.
There are numerous ways to add active ETFs to a portfolio. Investors can use them in a core/explore scenario. Here, investors can own passive ETFs for their core portfolio and add several key active ETFs to generate additional returns and reduce volatility. Or they could choose to go completely active in several key asset classes like fixed income. Either way, active ETFs make for a great portfolio tool.
Popular Active ETFs
These ETFs are sorted by their YTD total returns, which range from -3.9% to 9.6%. They have expense ratios between 0.17% to 0.36% and have assets under management between $5.1B to $30B. They are currently yielding between 1.3% and 8.5%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| JEPQ | JPMorgan Nasdaq Equity Premium Income ETF | $5.58B | 9.6% | 8.5% | 0.35% | ETF | Yes |
| DFUV | Dimensional US Marketwide Value ETF | $8.5B | 9.1% | 1.4% | 0.21% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $20.9B | 8.2% | 1.3% | 0.17% | ETF | Yes |
| JEPI | JPMorgan Equity Premium Income ETF | $29.2B | 5.7% | 6.3% | 0.35% | ETF | Yes |
| MINT | PIMCO Enhanced Short Maturity Active ETF | $9.7B | 1.7% | 5.2% | 0.35% | ETF | Yes |
| DFAT | Dimensional U.S. Targeted Value ETF | $8.2B | 1.7% | 1.50% | 0.28% | ETF | Yes |
| JPST | JPMorgan Ultra Short Income ETF | $22.8B | 1.3% | 5.1% | 0.18% | ETF | Yes |
| FBND | Fidelity Total Bond ETF | $5.1B | -1.2% | 4.6% | 0.36% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $6.7B | -3.9% | 1.9% | 0.25% | ETF | Yes |
The Bottom Line
Active ETFs are quickly growing in popularity. For those investors near or in retirement, they offer the ability to save on taxes and generate higher income while reducing volatility. Using them in a portfolio allocation makes a ton of sense in your golden years.
1 S&P Global (January 2023). SPIVA® U.S. Scorecard