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Active ETFs are on the rise: Morningstar

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Latest Morningstar data shows actively managed ETFs’ share of the US ETF market rose to 8.5 per cent at the end of March 2024, while actively managed mutual funds racked up significant outflows.

The firm writes that while the European market is rallying behind the trend, active ETFs currently comprise a modest segment, accounting for 1.9 per cent of total ETF assets in Europe. Unlike in the US, in Europe, like-for-like strategies aren’t typically available simultaneously in ETF and open-end fund format.

Morningstar launched two reports, providing an overview of the active ETF market in the US and Europe, assessing benefits and drawbacks of the ETF structure, comparing approaches by active managers, and breaking down trends and offerings by asset class.

“Investors are increasingly seeking out low-cost ETFs, and asset managers have more flexibility launching and managing ETFs since the SEC passed the ETF Rule in 2019. These factors combined to play a big role in catapulting the growth of the active ETF market in the US,” says Bryan Armour, Director of Passive Strategies Research at Morningstar. “Mutual fund companies began launching ETFs as the headwinds grew stronger for active mutual funds—but pivoting to ETFs isn’t a sure source of growth for these managers. ETFs are somewhat different than mutual funds, so investors must understand the nuances that ETFs introduce to actively managed portfolios. Capacity risks and wide bid-ask spreads can derail otherwise solid strategies.”

Key takeaways from the US report:

Active ETFs have exploded in number and assets in recent years, but they still represent a small slice of the ETF market (8.5 per cent) and active fund market (4 per cent).

Fixed income was the most popular active ETF asset class early on, but active equity ETFs have ascended the throne. Active multi-asset ETFs are few and far between since mutual funds and CITs dominate retirement plans.

Unlike mutual funds, ETFs can’t close to new investors when they get too big. Strategy capacity is critical in the ETF structure. Morningstar analysts recommend focusing on ETFs that hold liquid securities and reasonably diversified portfolios to avoid capacity risk.

ETFs present a growth opportunity for active managers, but assets have mostly funnelled to a few issuers, like Dimensional, and funds, like JPMorgan Equity Premium Income ETF.

Trading illiquid ETFs can be costly for investors. Waiting for an ETF to grow its asset base and build a track record can benefit investors.

“Assets in European active ETFs have seen exponential growth recently. Since March this year, European investors have accumulated approximately EUR33.8 billion in assets. While initial growth in the active ETF market coincided with a boom in bond strategies (in an environment of low interest rates where active management was seen as higher potential), equity active ETFs have gained significant momentum over the past two years, aggregating over EUR20 billion. Traditionally, most active managers were reluctant to disclose their ‘secret sauce’ by revealing their holdings daily, as required by ETF regulations. However, some fund companies are embracing ETFs as an additional distribution vehicle for their strategies,” says Monika Calay, Director of Manager Research, Morningstar

Key takeaways from the European report:

ETFs present a growth opportunity for active managers, but so far assets have mostly funnelled to a few issuers, like J.P. Morgan, Pimco, and Fidelity.

ETF investors love low fees. Reflecting this sentiment, the European market for active ETFs has exhibited a notable shift toward greater cost efficiency, with the asset-weighted representative cost decreasing to 0.27 per cent by March 2024 from 0.41 per cent in March 2013.

Unlike mutual funds, ETFs can’t close to new investors when they get too big. Strategy capacity is critical in the ETF structure. Focusing on ETFs that hold liquid securities and reasonably diversified portfolios is a good way to limit capacity risk.

Fixed income was the most popular active ETF asset class early on, but active equity ETFs have gained the throne as the menu of available options broadened.

Most of the active ETFs available in Europe are “shy-active,” with lower active share and/or tracking error than similar active open-end funds. The firm writes that, as a result, investors should moderate their excess returns expectations from such products.

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