Why You Should Pay Attention to Active ETFs

Active exchange-traded funds are a hot story and one that I have frequently talked about during the past couple of years. I tend to focus on how active strategies fit into the ETF wrapper, but this month, I am flipping the script and pondering the goals of active management and how ETFs can serve investors who prefer active management.

Active managers seek to outperform their benchmark. This can be a challenge because the collective performance of active managers is what sets the benchmark. For example, buying a security that active managers perceive as undervalued will drive its price higher, which would then be reflected in benchmark performance.

Nobel laureate William F. Sharpe wrote an article on this topic titled “The Arithmetic of Active Management” that was published in The Financial Analysts Journal in 1991. He posits that, in aggregate, active management is a zero-sum game where the gross return of the average actively invested dollar must equal the return of the average passively invested dollar. Passive management simply reflects the bets made by active managers. Active management’s zero-sum game turns negative after fees.

A couple of major caveats exist. Sharpe would consider active management to be any active risk away from the market portfolio, regardless of whether the strategy tracks an index or not. And Sharpe’s theory can’t be applied to mutual funds and ETFs alone because they are not in a closed system; investors can buy stocks directly or choose from other investing vehicles, like hedge funds, collective investment trusts, and so on. For this reason, supply/demand forces outside of mutual funds and ETFs affect performance.

Despite these considerations, Sharpe’s “arithmetic” remains a wonderful mental model for assessing actively managed ETFs. On average, investors should expect an active ETF’s managers to earn the benchmark minus fees. Therefore, the fee sets the hurdle for outperformance.

Morningstar’s Active/Passive Barometer illustrates the compounding effect of negative expected returns. Just 21% of the US active funds included in the report survived and beat their average passive peer over the decade through June 2025. Can active ETFs buck that trend in the next decade? I expect so, for a few reasons.

Active ETFs’ Advantage Over Mutual Funds

ETFs have several advantages over mutual funds. They generally include:

• Greater tax efficiency
• Lower fees
• Insulation from buying and selling by other investors in the fund
• Lower trading costs because of in-kind creations and redemptions

Tax efficiency won’t affect pretax returns and thus success rates, but reduced trading costs should marginally improve them. The main pretax benefit of active ETFs versus mutual fund peers is their lower fees.

If active managers are expected to earn the market return minus fees, then lower fees are an easy win for investors. In other words, active managers of low-fee ETFs face a lower hurdle to beat their benchmark than higher-fee mutual fund peers.

The average active ETF faces a 40-basis-point lower hurdle to beat its benchmark compared with the average mutual fund. This alone is a reason to believe that the growth of active ETFs should have a meaningful impact on future Active/Passive Barometer success rates.

Investors tend to prefer cheaper funds, too. The fee paid by the average invested dollar drops to 0.40% for ETFs and 0.58% for mutual funds. From this perspective, ETFs’ fee advantage over mutual funds shrinks, but the hurdle remains lower. Active ETFs should be more competitive than the average active mutual fund based on Sharpe’s arithmetic.

High-Quality Strategies Are Jumping to ETFs

Active managers long held out on ETFs because of their daily transparency. Some companies went to great lengths to create nontransparent ETFs for this reason. But the benefit of opacity is unclear for investors. In fact, performance and manager skill are less predictable in these types of strategies. ETF investors are used to transparency, so nontransparent ETFs never took off.

Yet, active managers are now racing each other to launch ETFs. Nearly 1,600 active ETFs have been launched since the start of 2024. Active managers’ change of heart on daily transparency largely comes down to revenue. Active ETFs are collecting inflows, while active mutual funds are bleeding outflows.

The expanding menu of active ETFs isn’t full of great strategies, but there were a few newcomers worth celebrating.

Neuberger Berman Small-Mid Cap ETF NBSM

Neuberger Berman took the plunge with a concentrated small-cap strategy in ETF form after 30 years of managing this strategy as a separate account and operating a similar mutual fund strategy in Neuberger Berman Genesis. This team’s resources and discipline create a strong foundation for building a portfolio of roughly 50 high-quality stocks. Investors should keep an eye on capacity, given this concentrated portfolio of small caps and mid-caps, but the Genesis fund currently manages $8.5 billion with about 100 stocks, so there’s plenty of room to run for this $210.0-million ETF.

Investors can expect lower risk than is typical of small-cap strategies, which could produce lagging performance in bull markets. That said, the Genesis fund had better risk-adjusted returns than category peers and its category index over the past decade. The ETF earns a Morningstar Medalist Rating of Silver, and we expect strong performance over the next full market cycle.

Jensen Quality Growth ETF JGRW

This is Jensen Investment Management’s first ETF, marking the addition of another asset manager among the selective ranks of High Morningstar Parent ratings. This ETF follows the same strategy as the 32-year-old mutual fund of the same name. It mostly hunts in large caps and follows a bottom-up, high-conviction process that filters out companies without a decade straight of at least 15% return on invested capital. The team conducts fundamental research on those that pass through the screen, ultimately ending up with a couple dozen steady growers trading at reasonable prices.

Investors can expect high conviction and high active risk from this strategy, yet relatively steady performance. Its stable of high-quality firms has kept a lid on volatility over the history of its mutual fund sibling.

Oakmark U.S. Large Cap ETF OAKM

This ETF marks portfolio manager Bill Nygren and Oakmark’s first. The ETF’s management team is the same as the Gold-rated $25 billion Oakmark Fund. This mutual fund has earned its keep by finding cheap stocks with strong managers, pushing the portfolio deep into value territory on the Morningstar Style Box. The ETF appears poised to follow in its footsteps, albeit with a bit leaner portfolio, given its large-cap-only mandate.

Oakmark U.S. Large Cap ETF investors can expect a bumpy but lucrative ride. Over the past decade, the sibling strategy Oakmark Fund has had a 30% higher standard deviation than the Morningstar US Large-Mid Cap Broad Value Index, but not all volatility is bad. Oakmark Fund’s return fell in the top 4 percentile among large-value funds during that time.

MFS

MFS launched the first mutual fund in the US over 100 years ago, but it was a late joiner to the ETF market, launching its first series of ETFs in December 2024. MFS launched five ETFs, including growth, value, and international stock ETFs, as well as core-plus and municipal-bond ETFs. Each strategy is unique, but the equity ETF portfolios should rhyme with existing mutual funds by the same names. Our analysts awarded Silver Morningstar Medalist Ratings for MFS Active Growth ETF MFSG and MFS Active International ETF MFSI, and a Gold rating for MFS Active Value ETF MFSV.

These newcomer ETFs pair strong related track records with lower fees and greater tax efficiency. Active ETFs appear poised to put up a better fight against their average passive peer than their predecessors.