State Street has found that in 2022, actively managed ETFs accounted for about 15 per cent of global net inflows in ETFs. By March 2023, that number had grown to 25 per cent. State Street argues that this increase in popularity of actively managed ETFs can be explained by changing supply and demand dynamics. Looking ahead, they expect these dynamics to not only remain constant, but also accelerate the growth and innovation of actively managed ETFs.
While the first active ETF was launched in 2008 in the United States, it was slow to take off as active ETFs were required to file for exemptive relief from some provisions of the Investment Act of 1940. This process could be both time-consuming and expensive, slowing the ability to launch and driving up breakeven thresholds. The Securities and Exchange Commission (SEC) first began considering new rules to modernize the regulation of ETFs in 2008, but the effort was tabled during the Global Financial Crisis. Efforts to launch ETFs with the same holdings disclosure as mutual funds began around the same time.
Rule 6c-11, or the ETF Rule, codified the exemptive relief process for ETFs that followed the provisions of the rule. This expedited the time to launch from several years to 60 days. As a result, legal costs were significantly reduced. Since the enactment of Rule 6c-11 in 2019, active ETFs exploded in number, growing from 325 to 1,071 funds in the US alone. In other words, it took 11 years for active managers to launch 325 ETFs before the rule, and a little over three years to launch close to 750 more.
Another regulatory change allowed ETFs to either reveal their portfolios less frequently or mask their true holdings using a representative set of securities known as a proxy. This created an avenue for active managers to launch ETFs and allowed new managers to enter the ETF marketplace that previously had frontrunning/free-riding concerns.
According to State Street, these changes in regulations led to many active mutual fund providers converting or creating “close cousins” of their existing active mutual fund strategies or adding new strategies to active ETFs. According to our data, about 46 actively managed mutual funds have been converted into ETFs since early 2021, and another 16 have been announced for 2023.
Changing rules made it easier to bring an active ETF to market while also enabling other asset managers to keep their “secret sauce”. As a result, by the end of 2022, the number of asset managers with active ETFs had quadrupled since the end of 2017, according to data from Morningstar.
Other countries have followed suit. Canada leads the active ETF market in terms of adoption. As of March 31, active ETFs account for over 27 per cent of the overall ETF assets under management (AUM) in Canada. Canada has some of the most ETF-friendly regulations, including:
- The ability to launch ETFs as a share class of a mutual fund,
- No daily holdings requirement, and
- Selective disclosure to a lead market maker, but not the broader marketplace
State Street suggests that this regulatory flexibility provides managers with greater confidentiality about their strategies and options to enter the ETF market.
They state that in 2015, Australia became the first Asia Pacific (APAC) regional market to allow actively managed ETFs. As of March 2023, active ETFs account for 18 per cent of the total Australian ETF market, up from seven per cent, five years ago. This shift has been driven by managers converting existing listed investment companies (LIC) into ETFs, as well as a flurry of new listings. It has also been fueled by the innovative dual access model now available to managers listing ETFs in Australia. The dual access structure enables active managers to run a single register for both unlisted and listed investments. As a result, managers can gain greater operational and investment efficiencies, and investors now have more options for accessing their preferred fund. The practice of adding an ETF share class to an existing fund structure is gaining popularity in the Australian market.
Active ETFs are also gaining popularity in the rest of the APAC region, reports State Street. South Korea launched its first active fixed-income ETF in 2017 and expanded to equities in 2020. There are now 118 active ETFs, making close to 18 per cent of the overall South Korean ETF marketplace. Similarly, China approved the first active ETFs for launch in 2020, and there are now 32 products making close to nine per cent of China’s ETF market. Both the Tokyo Stock Exchange and the Singapore Stock Exchange expect rule changes offering the ability to launch active ETFs in their respective countries in 2023.
Active ETFs are now the fastest-growing area in Europe, finds State Street. According to ETFGI, an ETF research firm, in March 2023, there were about 89 active ETFs in Europe with USD25.9 billion AUM. Initial concerns by some active managers around publishing their holdings on a daily basis have now dissipated, and the market is seeing traditional mutual fund managers enter the ETF arena with active strategies typically only seen in mutual funds. Recent comments from the European Union financial services chief, favouring a ban on inducements or commissions to banks, broker/dealers, platforms and advisors as an incentive for the sale of mutual funds, could be a catalyst for active ETFs in the region.
Such a ban would level the playing field, as ETFs do not offer such retrocession payments. The long-awaited retail investment strategy was published on May 24 and although not a full ban on inducements it introduces restrictions, safeguards and increased transparency requirements. The European market is also seeing an increase in the availability of active ETFs on platforms, making the products more widely available to the relatively untapped retail market, which is seeing huge growth in Europe post-COVID-19.
According to State Street, active ETFs have gained significant traction among investors as they combine the best of both worlds – the inherent efficiencies of the ETF structure and the alpha-generating capabilities that active management can bring. According to Factset, investors in particular favored low-cost equity and fixed-income ETFs in 2022. Nearly 80 per cent of all cash flows went into ETFs with expense ratios below the 44 basis points (bps) industry average. The average fee for an actively managed equity ETF reduced to 0.38 per cent, less than half of the 2019 level. Active fixed-income ETFs followed suit, at 0.37 per cent. If fee compression continues, FactSet expects active equity ETF fees to come down to 0.31 per cent by the end of 2023.
State Street contends that the other benefit of active ETFs in certain jurisdictions is tax efficiency. Mutual fund investors who invest outside of tax-exempt structures face adverse tax treatment in the US. They must not only pay capital gains tax when they exit a position but are also taxed when their fund is forced to sell winning positions because other investors have exited. ETFs can redeem securities in-kind, minimising the need to sell securities in order to meet investor redemptions. This can reduce the amount of capital gains realised by the fund, thereby reducing the tax burden for investors. Due to a quirk in their structure, ETFs are largely immune to this latter element. Researchers at the Wharton School of Business at the University of Pennsylvania have found that demand for ETFs is being driven primarily by tax considerations, the report says.
State Street finds that ETFs provide investors with greater flexibility than mutual funds to buy and sell a low-cost security, replicating a broad portfolio of stocks at negotiated prices throughout the trading day. Active ETFs expand on this flexibility by offering broader investment choices than currently available to active mutual funds. This can help investors capitalise on an emerging market trend, or react to an adverse market event swiftly, and potentially generate higher returns. This is not to say that active ETFs can eliminate the underlying risk of equity or bond markets. However, they may enable investors to find solutions that better suit their personal preferences when investing in capital markets – including both equities and fixed income. With rising inflation and rate hikes, markets are expected to remain volatile in the near-term. Active ETFs could provide the necessary flexibility and diversification that investors are looking for in the current volatile investment environment.
Actively managed ETFs are still only a fraction of the expanding ETF universe. According to ETFGI, active ETFs account for only 5.5 per cent of the almost US10 trillion global ETF market. Active ETFs’ growth in double digits has only occurred in the past few years. This leaves plenty of room for the category to expand, with some analysts projecting nearly eightfold growth over the next five years to US3 trillion.
State Street expects growth to accelerate driven by regional expansion. For example, active ETFs make up less than two per cent of the European ETF market, yet are the fastest growing segment of the market in 2023. According to the firm’s recent report, ETFs 2023 Outlook, there are a number of regulatory changes that will drive the growth of ETFs in the European market this year.
Additionally, asset diversification should drive active ETF growth. In 2017, the majority of active ETFs were held as bond funds. In 2022, equity funds became dominant. Active fixed income ETF managers could experience outsized inflows, with the added advantage of being nimbler to swap out bonds as rates change. State Street believes that the innovation of single bond ETFs and more precise targeted strategies will be an accelerant to growth as investors look to the liquidity of the ETF vehicle to gain easier access to the less liquid fixed income marketplace.
Finally, innovation around structures and themes will continue, according to State Street. The growing popularity of sustainable investing, cryptocurrencies, the bio revolution and more could be potential growth drivers for active ETFs. Technology also has the potential to further accelerate innovation in the active ETF space. For example, the use of artificial intelligence and machine learning could enable asset managers to develop sophisticated investment strategies that are better able to adapt to changing market conditions.
