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2 Active ETFs We Like

A look at the active ETF landscape along with some pros and cons.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Fidelity recently launched ETF equivalents of a few of its actively managed mutual funds. Joining me today to talk about the state of the state of active ETFs and to share a couple of his favorites is Ben Johnson. Ben is Morningstar's global director of ETF research.

Hi, Ben. Thank you for being here today.

Ben Johnson: Hi, Susan. Thanks for having me.

Dziubinski: Let's first talk a little bit about how big of a role active ETFs actually play in the marketplace today? And how have investors embraced active ETFs?

Johnson: Well, Susan, today actively managed ETFs play a limited role in the overall ETF market, and they were relatively late to start. So, while the first ETF, SPY, was launched in 1993, the first actively managed ETFs, which were actually launched by Bear Stearns, didn't come to the market until 2008.

If you fast-forward to the end of January, what we saw is that there are now 500-plus actively managed ETFs on the menu in the United States. And they, combined, account for about $193 billion in assets under management. So, that's roughly a fifth of the overall number of ETFs and a relatively modest 3.5% or so of the trillions of dollars that are invested in ETFs.

Dziubinski: What would you say are some of the newest or, let's say, the most noteworthy actively managed ETFs?

Johnson: I don't think there is any arguing that the most noteworthy actively managed ETFs in the past few years have been the ARK family of ETFs. Cathie Wood and her team at ARK have delivered absolutely mind-bending returns for their investors. Across the board, what we've seen is double-digit compounded returns, putting them really in the record books by virtually any measure with respect to how those funds have performed since their inception. And investors have taken notice. That family of funds has taken in over $28 billion in net new money through the 12 months ending in January. And that accounted for 40% of overall flows into actively managed ETFs in that period.

It's gotten to the point where Cathie has become a global sensation. It recently came to light that she's earned herself the nickname "Money Tree" amongst Korean investors. This is a phenomenon, I think, unlike any I've ever seen within the asset management industry. Cathie has become sort of the Beatles of the ETF ecosystem, which is really just pretty, pretty remarkable. Pretty incredible.

Now moving on from noteworthy to new, you'd mentioned at the onset, Fidelity has come into the space in a more meaningful way. Now, Fidelity has actually long been a player in ETFs. They actually launched a Nasdaq ETF, ONEQ, years ago, but only more recently meaningfully invested in this space, first launching a series of individual sector-focused ETFs, subsequently some factor-focused ETFs, and most notably perhaps and most recently, little siblings, ETF siblings, nontransparent, actively managed ETF siblings of some of its flagship strategies. And the latest it added to its table was an ETF version of Fidelity Magellan, which has just come out in the recent weeks. So, a very meaningful development--for headline-making purposes, if nothing else--that Peter Lynch's former charge is now available to investors in an ETF format.

Other newsworthy developments of late have been Dimensional Fund Advisors' entry into the ETF space. DFA had long been a holdout and had its toes on the edge of the pool and finally jumped in feet first late in 2020. If you look forward to 2021, it's notable that the firm is actually going to convert six of its tax-managed mutual funds to ETFs later this year.

And then last but certainly not least, we've gotten news recently from Capital Group, the firm behind the American Funds range, that they will be entering the ETF space with a lineup of active nontransparent ETFs of its own. They made a big hire on the ETF front, bringing Holly Framsted from BlackRock. Holly's got a tremendous resume, a tremendous amount of experience, has seen the ETF industry from a variety of perspectives. And I take that as an indication that Capital Group has been very thoughtful and is very serious about entering the ETF market after being a holdout for a very long period of time.

Dziubinski: Ben, what should investors who might be thinking about pursuing active strategies in the ETF wrapper--what are some of the pros and cons they need to be aware of?

Johnson: Well, the pros I think, are clear and they're meaningful. First and foremost, the ETF wrapper is simply a more tax-efficient means, a fairer means, of delivering actively managed strategies. The way that money moves into and out of ETFs is fundamentally different from how cash moves into and out of mutual funds. And it's to the benefit of all shareholders. Those frictions that are created by investors coming and going from the fund, in an ETF are turned inside out, they're externalized, they're paid by people as their buying and selling. That includes transaction costs. That includes, most notably, the tax costs involved in buying and selling those portfolios. Because ETFs can send securities out of the portfolio in kind without actually liquidating them in order to meet redemption requests, it means they've tended to be much more tax-efficient relative to mutual funds, which oftentimes have to sell down positions to give shareholders their money back.

ETFs can also be more fee efficient. So, if you think about all of the different costs that are embedded in funds' expense ratios, ETFs tend to strip that down to the cost of manufacturing, the cost of portfolio management. What get cast aside are things like marketing and distribution costs, as well as certain shareholder recordkeeping costs. So, the ETF format is going to be a more cost-efficient means of consuming these strategies. You also have to think about it from the point of view of buying and selling as an individual shares in the fund. So, most ETFs now trade on a commission-free basis across major brokerage platforms, whereas some mutual funds will still charge ticket charges, commissions, when buyers and sellers are transacting in those fund's shares. So those are real and meaningful pros. The other pro I would add is just access. Investors can access ETFs in investment amounts as low as a single share, whereas investment minimums on many comparable mutual funds might be much higher. So, this really democratizes access at an institutional price point for a larger number of investors who are interested in these particular strategies.

As for the cons, the chief con, I would argue, is that the portfolio managers themselves lose certain latitude that they might have trying to ply their strategy in a traditional mutual fund. One way in which they lose a degree of latitude is that in the case of actively managed nontransparent ETFs, they cannot invest in securities that don't trade at the same time as the fund itself. Now this could ultimately change with time. But this is somewhat restrictive, to be limited in your investment opportunity set to just those things that are trading at the same time your fund is on a U.S. stock exchange.

The other, and I would argue the more important, limitation that managers face in operating an ETF is that they lose an all-important tool in their toolkit when it comes to managing capacity. What we've seen over the years is that many savvy managers know when they've got enough on their plate, when the next dollar coming in the door would potentially diminish the efficacy of their strategy. They would have to add that dollar to positions that may have appreciated in value and no longer look like compelling valuations. They may have to allocate that next dollar to their next-best ideas, which could also risk diminishing the efficacy of their strategy, hurting their performance.

So, an ETF can't close. It can't do a soft-close, it can't do a hard-close, it can't tell investors, "Sorry, but we can't take your money right now." And going back to the example that I shared earlier with the ARK family of funds: This is an area of potential concern because that particular family of funds now is taking on, in some days, billions of dollars of new money from individual shareholders, investing in smaller names where it has already very concentrated stakes, and "asset bloat," as we've referred to it historically, is a real risk in that instance.

Dziubinski: Ben, let's name some names now. How about a couple of actively managed ETFs that we rate pretty highly at Morningstar?

Johnson: Well, I have a pair for you. And what I would stress is that what we like about actively managed ETFs is what we like about all investment strategies, be they active, passive, in between, be they delivered to investors in a mutual fund format, an ETF, a separate account, you name it. We look really at those key pillars that support the Morningstar Analyst Rating and notably, in the case of actively managed ETFs, we want to understand the process being employed, and the people who are implementing that process. Those are two key drivers of our rating in the case of actively managed strategies.

So, two of our favorites in this space--I'll share one from the world of stocks, and the other comes from the world of bonds. 

The first is the Avantis U.S. Equity ETF. Ticker for that one is (AVUS). We've assigned it a Morningstar Analyst Rating of Bronze. Now Avantis is a firm that was stood up by former DFA co-CEO Eduardo Repetto. And Eduardo has subsequently brought over a number of his former colleagues from Dimensional Fund Advisors to basically build what I've referred to as "DFA 2.0." Avantis' strategies have shared DNA with DFA. They look to improve on DFA's secret formula in certain ways. But the commonalities are really leveraging the wisdom of the market, first and foremost, and then tilting toward factors, toward different sources of return, that have shown that they can outperform the market over long periods of time. So, in this case, one of those factors--the all-important factor that's been missing in action for some time--is value. AVUS is a great option to look at for broad-based exposure to U.S. stocks, that has tilts toward relatively higher-quality, relatively cheaper names from that universe.

The second fund is the Pimco Enhanced Short Maturity ETF. The ticker there is (MINT). Now, Jerome Schneider and his team at Pimco are a known quantity to our group. They've been very successful over a very long period of time and especially so in this particular charge, which is focused on the very short end of the yield curve and was originally designed as being effectively a money market substitute of sorts. And indeed, that's how many investors have come to use that particular fund. We have a high degree of confidence in that team, we have a high degree of conviction in their process, and the fund earns a Morningstar Analyst Rating of Gold.

Dziubinski: Ben, thank you so much today for your time, giving a little bit of an update on the lay of the land when it comes to active ETFs and of course for sharing those picks. We appreciate it.

Johnson: Well, thanks for having me, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

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