Active ETFs Take Off—3 Ideas for Investors

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Apple exceeded expectations in its fiscal second quarter. Hear why Morningstar remains cautious about the tech company’s future. Plus—a game changer has shaken up active ETF investing. The editor of Morningstar ETFInvestor newsletter will join the podcast to discuss the new frontier and spotlight some favorite active ETFs. And—how investors can use an investment strategy called “asset location” to their benefit. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Apple Outperforms in iPhone and Services

Apple’s fiscal second-quarter results surpassed expectations. IPhone sales and services like the App Store and iCloud outperformed. But revenue declined 3% with a drop in iPad and Mac sales in the March quarter. Morningstar had been anticipating a slowdown of strong growth in hardware products. Remote work and school and the initial rollout of 5G boosted demand for several years. Morningstar is pleased with the iPhone and services segments’ modest growth despite other areas falling on a year-over-year basis. The analyst remains cautious about the next several quarters for Apple as macroeconomic headwinds persist. However, the tech titan should fare better than many of its smartphone peers. Morningstar is maintaining its $150 estimate of Apple’s stock and views shares as overvalued.

SoFi’s Deposit Growth Drives Up Net Interest Income

SoFi Technologies benefited from more deposits and rising interest rates in the first quarter. Morningstar thinks both helped the digital bank deliver strong net interest income, or what a bank earns from making loans. However, revenue growth slowed companywide. SoFi reported a net revenue increase of 43% year over year. It climbed to $472 million. Revenue growth is outpacing expenses with the per-share-loss gap narrowing compared to last year. SoFi’s lending segment is its largest source of revenue because of net interest income’s growth. The larger deposit base has allowed the company to make more loans. Overall, the lender has made more loans but seen contraction in some areas like student loans. And the number of new student loans has declined compared to last year. Student loan forbearance and higher interest rates have hit the area hard. SoFi is counting on the recent acquisition of Wyndham Capital to help resolve loan-processing issues. Morningstar is sticking with its $14 estimate of SoFi’s stock and thinks it’s undervalued.

Strong Year-Over-Year Improvement for Ford

Ford’s first-quarter earnings beat estimates. Its adjusted $0.63 per share topped the $0.41 prediction that was the Wall Street analyst average. Morningstar thinks macroeconomic fears beyond management’s control may be holding Ford’s stock back. The automaker confirmed but didn’t raise its 2023 outlook, unlike rival GM, which recently did. Ford’s end-of-quarter balance sheet seems to be in solid shape to handle recession risk. Its total available funds sit at more than $46 billion. And management expects strong pricing headwinds for the rest of the year, especially in the Ford Blue segment. The division consists of gas-powered and hybrid vehicles not sold to commercial customers. The commercial Ford Pro segment saw year-over-year pricing gains, and it should do well this year with the launch of the new Super Duty pickup and continued sale of software. Morningstar expects cost headwinds to improve as 2023 unfolds because the bulk of last year’s cost increases came after the first quarter. However, macro uncertainty, lower Ford Credit income, and rising loan losses will likely create challenges. Morningstar still estimates Ford’s stock is worth $20 and considers it undervalued.

Coinbase’s Losses Narrow

Crypto exchange platform Coinbase reported improved first-quarter results. Better cryptocurrency market conditions, increased interest income, and cost-cutting efforts helped reduce losses. First-quarter net revenue fell from last year but increased from last quarter to almost $773 million. Meanwhile, the company pared its first-quarter net loss to $79 million from a loss of $430 million last year. Coinbase’s revenue growth came from its trading business and subscription and service segment. Pricing drove trading revenue’s increase and not volume. That remained flat from last quarter. Major cost-cutting puts the firm’s spending on much better footing, and while painful, Morningstar sees these reductions as necessary in difficult market conditions. Coinbase is facing regulatory uncertainty due to SEC scrutiny and remains exposed to volatile cryptocurrency markets. Morningstar still thinks Coinbase shares are worth $80 and are undervalued, although a wide range of outcomes are possible with the stock.

The Active ETF Boom

A game changer is providing more opportunities for investors. Many active managers are launching active ETFs to remain relevant. So, what’s happening with this so-called “space race”? Bryan Armour is the director of passive strategies research for North America for Morningstar Research Services. He’s also the editor of the Morningstar ETFInvestor newsletter.

Ivanna Hampton: Bryan, you’ve written about how active managers have flocked to active ETFs in recent years. What brought about the change?

Bryan Armour: Five years ago, there were 11 strategies, active ETFs, with over a billion dollars in assets under management, and 10 of those 11 were in fixed income and they were in ultrashort bonds, bank loans, more niche strategies, so there wasn’t wide adoption. Then in 2019, the U.S. Securities Exchange Commission adopted the ETF rule, and the biggest takeaway from that was that issuers are able to use custom creation and redemption baskets.

Most people trade on the secondary market when they trade ETFs, but the real advantages of ETFs come in the primary market, and in the primary markets, the authorized participant makes an exchange with the issuer, which is basically they give a basket of securities that they exchange in kind for ETF shares, and that’s a creation. Then the redemption would be they would give their ETF shares back and receive securities from the portfolio. Five years ago, APs were required to use a pro rata slice, so it had to mimic the actual portfolio of the ETF. And when they created shares, that’s what they handed in. When they redeemed shares, that’s what they got back.

And then with the ETF rule, that changed to where portfolio managers were able to set what those baskets included, and it didn’t have to match the portfolio, and that gave increased abilities to manage taxes and then also more portfolio management capabilities. So that was a big game changer for active managers.

Hampton: Where does the ETF market stand today in terms of assets under management and strategies?

Armour: There are thousands of strategies overall. There’s $7 trillion in ETFs, about 5.5% of that is in active ETFs. We’ve seen faster organic growth in active ETFs than the rest of the ETF market. So, we expect that market share for active ETFs to continue to grow.

But what we saw in 2022 was about a trillion dollars of investors’ money flow out of active mutual funds and about $90 billion flow into active ETFs. So, it’s pretty clear investors are seeing better opportunities in active ETFs right now.

Hampton: So, you’re really seeing a shift within this space. Morningstar talks about how investors would benefit from a diversified low-cost portfolio with a solid track record. How would an investor practice diversification while also investing in active ETFs?

Armour: We definitely talk about it a lot—having diversified low-cost portfolios. But active ETFs, active strategies in general, diversification benefit is a little murkier. So, the counterpoint to diversification is investors wouldn’t want a manager’s 101st best idea diluting the portfolio. So, there’s really two different approaches, and it depends on the strategy, but there are two different approaches. The top-down approach, which is you take a market portfolio, you tilt it toward characteristics that you see as providing an edge over the long term. And then the other approach is bottom-up approach, which is based on really company-specific research that the manager’s performing and selecting individual stocks one at a time.

So, with the former top-down, you want a diversified portfolio where you can capture the market beta and tilt toward your advantage. With the bottom-up side of things, you just have to be careful because even when you have a good odds of success, you can still lose with concentrated strategies like that if you don’t size your bets properly.

Hampton: What can costs tell us about a fund’s success?

Armour: Costs are the most reliable predictor of a fund’s success that we’ve found in our research. Morningstar Active/Passive Barometer, the most recent version, found that the cheapest quintile of funds within a category had double the odds of success against the average passive peer over the most expensive quintile of funds. So, fees are critical no matter what area of the market, what strategy you’re going after. And Jack Bogle, I think, said it best when he said, “In investing, you get what you don’t pay for.”

Hampton: That’s important to remember. Now, your article warned investors they should not chase performance because there’s risk of bubbles popping up. Can you give us an example of that?

Armour: The go-to example would be ARK Innovation ETF, and taking a step back, the disadvantage, the only risk that active ETFs have versus an active mutual fund is capacity constraints because mutual funds can close to new investors; ETFs can’t. So, ARK Innovation ETF ran into an issue where they had incredible performance in 2020, gathered huge assets in 2020 and the following year, and they couldn’t close to new investors.

It was a concentrated portfolio of smaller companies for the most part. So, what happened is you saw the tail wagging the dog in that scenario where the price/book, the valuations of the companies within the portfolio, on average, doubled in 2020, so it was an unsustainable price increase. In 2022, we saw investors pay for it. So those that came in late got absolutely crushed in 2022.

Hampton: Were there any signs, like if you were an investor in that to know, “Hey, I should pull out now?”

Armour: Yeah, going back to fundamentals is always good. It’s easy to get caught up in the narrative, in the hype, but when you see something at an unsustainably high price compared to the fundamentals of the companies it holds, that’s a huge red flag.

Hampton: All right. So, what are some ETFs that have received Morningstar Analyst Ratings of Silver or Gold? What are your favorites?

Armour: One of the best developments coming out of active ETFs is the influx of great mutual fund managers that were holding off to adopt ETF structure until the ETF rule came along. So, we have five different asset managers that currently have funds receiving a Silver or Gold rating, and those include Dimensional Fund Advisors, Fidelity, Pimco, T. Rowe Price, and JPMorgan. Within those strategies, we see a lot of time-tested strategies that have done really well in the mutual fund industry and brought over to ETFs. So, three that I’m just going to mention right now, the Dimensional Core Equity 2 ETF, which holds—when we were talking about the top-down approach—it holds 2,500 stocks and basically just tilts toward lower valuations, higher profitability, and smaller size. They see those as long-term advantages, and it comes with a low cost of 17 basis points. So, very well-diversified, low-cost portfolio.

Another one is the Fidelity Total Bond ETF, and that one holds about 2,500 bonds including Treasuries, corporates, and securitized debt. So, that’s another diversified portfolio that has a little bit more flexibility than other passive options, and it’s shown up in performance. It’s about top-10 percentile over the past five years.

And then the third strategy is T. Rowe Price Blue Chip Growth ETF. T. Rowe Price has long been a leader in growth strategies, and bringing it into ETF form, it just gives the investors another opportunity across the board between value, growth, core, and all sorts of different strategies. But this one only holds about 75 companies, and so it’s better to use this in a supporting role to more core strategies within your portfolio.

Hampton: Bryan, thank you for this conversation and identifying three ETFs as earning high marks from Morningstar. Thanks for your time today.

Armour: Thank you.

Best Practices for Tax-Efficient Portfolio Management

Hampton: Investors, like homebuyers, may want to consider location when deciding where their assets will live. Check out this conversation about the “best practices for tax-efficient portfolio management.” Here are Morningstar Inc.’s director of personal finance Christine Benz and financial planning expert Michael Kitces.

Christine Benz: Hi, I’m Christine Benz for Morningstar. The topic of asset location, not to be confused with asset allocation, has gained new importance now that yields are higher. I recently sat down with financial planning expert, Michael Kitces, to discuss how investors and their advisors should approach that question.

Michael, thank you so much for being here.

Michael Kitces: Absolutely. My pleasure. Appreciate the opportunity.

Benz: I’d like to talk about asset location, where to hold different types of assets, assuming I have multiple account types. This was a topic that was kind of hard to get excited about when yields were so low. It’s like, well, what difference does it make, really, if someone is getting a 1% yield or a 2% yield on their bonds? But now that we are meaningfully higher with income, which of course is taxed at ordinary income tax rates, can you share some thoughts on that asset-location question?

Kitces: Asset location to me has gone through an interesting evolution over the past 20-odd years that there’s really been a growing focus on it. So, if we go back to the 1990s—we only made Roths in the late 1990s, and frankly, IRAs and 401(k)s were still in their early stages of gaining momentum then. It’s really the past 20 years that we’ve seen much bigger IRA and 401(k) balances. We’ve gotten more ways to move money in and out of retirement accounts. The overall contribution limits have gotten bigger, so we’re able to get more dollars in there and we’ve got this third bucket of tax-free Roth that the asset-location decision on the one hand has become more complex and on the other hand means there’s actually just literally more dollars and more opportunity to do this well, like I have more money and more buckets to choose from, more choices means more economic benefit if I get this right and, conversely, more economic harm if I get this wrong.

When I look at these asset-location decisions overall, the basic rule for this usually is pretty straightforward. Anything that’s ordinary income may as well go inside of an IRA because it’s going to be ordinary income no matter what, whether you draw it out of an IRA or it’s taxed in taxable account, but at least you put it in an IRA, it’s tax-deferred and you can control the timing of when this gets recognized into the future when you take a withdrawal instead of today. And so, that usually led to some kind of basic rule of thumb, like bonds that generate ordinary income go inside of the IRA and stocks that generate capital gains go in brokerage accounts so that you still get the capital gains treatment.

The problem that though—and we published a lot of research around this back in the early 2010s—when interest rates got so low, I mean, coming off financial crisis down to near 0 for a while and barely 2% on intermediate Treasuries, the yields got so low that the irony is, taking a low-yielding investment and putting in a tax-deferred account doesn’t actually really do much for you. The difference between tax-deferred compounding growth versus not tax-deferred compounding growth on 2 is not actually that much different. There’s just not that much compounding that happens when the yield base is so low in the first place. Compounding is a very powerful thing in the long run, but compounding low numbers only compound so far; compounding big numbers compound at much bigger levels. And because of that, what we actually found in our research is that because the yields were so low and there was so little benefit to get tax-deferred compounding growth on bonds, it was often actually better to put stocks inside of the IRAs, even though you might convert capital gains to ordinary income because you could get tax-deferred growth for very long time periods.

If I look practically from any investor’s portfolio, even those of us that tend to buy and hold, most people I know who are even buy-and-hold-oriented, if I pull up their portfolio today and I say, “Oh, this is really cool, like, show me what you had in 1993.” It’s not the same. Investment markets were different. ETFs barely existed. We lived in a mutual fund world. You couldn’t even buy it on an online platform because that didn’t exist. The nature of markets themselves change, and from time-to-time funds change, offerings change. And even if you take like a very low-turnover portfolio, like a 10% turnover portfolio—so we’re only changing investments once a decade on average—if we actually look at how that adds up over 30-plus years, once-a-decade turnover still drags so much lost return over multidecade time periods that we found for investors with really long time horizons, it was still better to put the stocks inside the IRA, give up the capital gains treatment to avoid the tax drag of even very low turnover and to the extent you’ve got anything that’s a dividend yield, if you’re getting a portion of returns in dividends instead of capital appreciation, that’s essentially like forced turnover …

Benz: You have no control.

Kitces: … you have no control. It is coming through. You are getting taxed on it, which means you are experiencing the tax drag that goes with it, again, usually at preferential qualified dividend rates. But it’s an annual tax drag that again gets a little more turbocharged inside of an IRA. And so, we found for investors with long time horizons, the yields on bonds were low enough that there was some value to putting stocks inside of IRAs and getting that tax-deferred compounding growth.

Now, however, our investment realm starts to shift. Right now, we’re seeing bond yields are getting higher and, suddenly, the value of tax-deferred compounding growth when I might get 5-plus looks very different than the tax-deferred compounding growth when I was getting 2. And so, one of the things even that we’ve always done with clients within our firm is revisiting asset location on an ongoing basis. I kind of think of this as like you can make the priority list of what’s most important to put in the IRA, what’s most important to put into the brokerage account. And as your investment views or investment assumptions or just the investment environment changes, so too does the nature of the priority list. Maybe I’m more bullish on something and I think it’s really got a great return opportunity, so I’m pushing it out to the Roth. And then, it appreciates a lot and all of a sudden, I’m not as excited about it anymore and maybe I don’t necessarily want it in the Roth. Or in this case, maybe I was not so excited about putting my bonds in the IRA because it actually wasn’t worth much to get tax-deferred compounding growth. I may as well leave it in a brokerage account. If I’m tax-sensitive, I’ll just buy a muni bond in the brokerage account. Now, suddenly, as yields are higher, well, putting bonds inside of the IRA starts to look more appealing again.

And so, nature of asset location to me is just—it is actually something that is more dynamic than often we’re giving it credit for with the simple rule of thumb of like bonds in the IRA because they’re already ordinary income and stocks in the brokerage account because they’re already capital gains. The relative weightings of these investments means the optimal location as you’re adding new dollars can actually shift over time. That’s part of the nature of how this works.

Benz: Michael, this has been such a helpful discussion. We’ve covered a ton of ground. Thank you so much for being here.

Kitces: Absolutely. My pleasure. Thank you.

Hampton: Thanks Christine and Michael. Subscribe to Morningstar’s YouTube channel to see videos about investment ideas. You can hear market trends and analyst insights from Morningstar on your Alexa devices. Say ‘Play Morningstar’. Thanks to senior video producer Jake VanKersen. And thank you for tuning into “Investing Insights.” I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.

Read about topics from this episode.

Apple Earnings: Hardware Headwinds Look Ominous; Stock Overvalued Versus $150 Fair Value Estimate

SoFi Earnings: Deposit Growth Drives Net Interest Income Higher, but Growth Slows Sequentially

Ford Earnings: Strong Year-Over-Year Improvement and a Cash-Rich Balance Sheet Are Good to See

Reducing Fair Value Estimate for Coinbase

The New Frontier of Active Investing

Michael Kitces: How Higher Yields Affect Asset Allocation and Retirement Planning