Exchange traded funds (ETFs) revolutionized portfolio management, investing and even day trading. These packages of stocks, bonds, futures and other asset classes instantly made it easier for investors of all sizes to build portfolios, make trades and produce great returns. And they’ve done so for extremely low costs and tax savings.
But, the best days could still be ahead.
The creation and growth of active ETFs are providing plenty of potential for investors and the fund structure itself. Thanks to investor demand and other factors, active ETFs could quickly replace mutual funds as the only fund structure in town. Ultimately, investors would win out on that front.
ETFs Were a Game Changer
The first ETF was originally launched in Canada, but the fund form took off when State Street Global Advisors launched the Standard & Poor’s Depositary Receipt (SPY). The SPDR was designed to track the S&P 500 and, ultimately, proved to be a huge hit with investors. Since then, the SPY has grown to hold more than $400 billion in assets and trades more than 80 million shares per day.
The SPY also kick-started the ETF movement. Soon enough, the number of ETFs exploded, and the number of funds stretched into the thousands, covering a wide range of asset classes and strategies.
But, the movement has mostly been tilted towards passive funds. This, however, has begun to change – active management is now on the table.
Opening the Cage
Thanks to several key pieces of legislation being changed, active ETF usage and launches have exploded in recent years.
For starters, Rule 6c-11, also called the ETF Rule, codified the relief process for ETFs and allowed active strategies to be born. This improved the launch process and reduced SEC approval times from several years down to just 60 days. Since the 2019 enactment of Rule 6c-11, the number of active ETFs has surged – growing from 325 to 1,071 in the U.S. alone.
Secondly, recent changes to how active ETFs disclose their holdings have caused a huge wave of launch activity. Previously, ETFs needed to disclose their holdings on a daily basis. Not a big deal if you’re tracking the S&P 500, but for active management trying to keep their models hidden, it is. Thanks to relief granted by the SEC, managers can use semi-transparent or non-transparent structures to hide their methods, keep prying eyes out of their returns, and prevent front running in their portfolios.
Finally, mutual fund to ETF conversions as well as the recent expiration of Vanguard’s patent to allow ETFs to be a share class of existing mutual funds have driven additional launches.
According to State Street – the creator of the first real ETF – this has opened the cage for issuers to launch unlimited number of active ETFs.
Just like the U.S., many foreign regulatory bodies have started to embrace active ETFs and follow a similar rules structure. For example, Canada has adopted ETFs as share class rules with no daily holdings reporting requirements while providing selective disclosure to lead market makers only. Similarly, Australia and the APAC market have adopted new progressive active ETF rules, while Europe has embraced the form with gusto. Europe remains the fastest-growing market for active ETFs with expanding launch activity.
Investors Want Structure
The new rules have been met with rising investor appetite for active ETFs. It’s here that State Street predicts unlimited potential. It turns out, investors love what ETFs can do for portfolios.
Take their low costs for example. According to the firm’s data, nearly 80% of all 2022’s cash flows went into ETFs with expense ratios below the 44 basis points (bps) industry average. These days, the average fee for an actively managed equity ETF is just 0.38%, while active fixed income ETFs clock in at 0.37%. This helps explain why several active ETFs now court billions in assets.
Investors also love the fact that they don’t have to pay taxes on capital gains. The structure’s ability to pass through taxes using the creation-redemption mechanism wins out over mutual funds and other structures. Then there is the potential to lower volatility and trade, which helps active ETFs win out over other structures.
It is here that State Street has dubbed the latest phase of ETFs as “ETFS 3.0”. With rising demand and continued rules changes, the structure has unlimited potential to become the only way investors build portfolios. This will have ETFs overtaking mutual funds and replacing them as the preferred vehicle of choice.
Top-Performing Active ETFs
These funds were selected based on a 1-year total return, which ranges between 4% and 58%. They have expenses between 0.09% and 0.75% and assets under management between $6B and $30B. They are currently yielding between 0% and 9.4%.
| Ticker | Name | AUM | 1Y Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| ARKK | ARK Innovation ETF | $6.8B | 57.7% | 0% | 0.75% | ETF | Yes |
| DFUS | Dimensional U.S. Equity ETF | $6.6B | 24.4% | 1.37% | 0.09% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $20.9B | 19.5% | 1.43% | 0.17% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $6.65B | 19.1% | 1.6% | 0.25% | ETF | Yes |
| DFAT | Dimensional U.S. Targeted Value ETF | $7.8B | 16.5% | 1.4% | 0.28% | ETF | Yes |
| DFUV | Dimensional US Marketwide Value ETF | $8.2B | 11.2% | 1.91% | 0.22% | ETF | Yes |
| JEPI | JPMorgan Equity Premium Income ETF | $29.1B | 8.5% | 9.33% | 0.35% | ETF | Yes |
| MINT | PIMCO Enhanced Short Maturity Active ETF | $9.7B | 5.3% | 5.5% | 0.35% | ETF | Yes |
| FTSM | First Trust Enhanced Short Maturity ETF | $7.5B | 5.1% | 4.9% | 0.45% | ETF | Yes |
| JPST | JPMorgan Ultra Short Income ETF | $23B | 4.1% | 4.2% | 0.18% | ETF | Yes |
In the end, investors are the ones that win. Active ETFs combine the best of both worlds, allowing investors to build strong portfolios that can provide plenty of benefits at a low cost. Any growth here should be a welcomed sign.
The Bottom Line
Thanks to several rule improvements, active ETFs are quickly becoming the structure for all investors. Thanks to rising demand and continued growth, State Street believes that there is unlimited potential for the active ETFs going forward and they very well could be the only way for investors to build portfolios.