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Active ETFs explode in popularity

Key takeaways

  • Actively managed ETFs do not have to disclose their holdings daily.
  • Demand for these types of ETFs has grown dramatically.
  • The number of actively managed ETFs is expected to increase.

While still representing a relatively small portion of the roughly $9 trillion ETF universe, actively managed ETFs are exploding in popularity. Consider this: Active ETFs now represent nearly 9% of ETF assets under management, up from roughly 2% in 2019, according to data from Morningstar.

Let's explore actively managed ETFs and whether they are right for you.

ETF universe expanding

Many investors and financial advisors like ETFs because they can offer tax advantages compared to some other alternatives, can be traded intraday, and offer transparency into underlying holdings, among other potential benefits. Perhaps most importantly, investors and advisors have gravitated to ETFs due to their generally lower relative cost.

The degree of transparency is the key differentiator between active stock ETFs and the majority of ETFs in the market today. There are more active ETFs (1,473, as of June 2024) than ever before, with more launching on a continuing basis as well as many mutual funds converting to actively managed ETFs.

Investors might pick actively managed investments (like many mutual funds and ETFs) based on the belief that rigorous research, sophisticated portfolio construction, and expert trading may add value for shareholders. Actively managed ETFs are a portfolio of subjectively chosen investments by a fund manager, rather than those chosen via a rules-based index that defines a passively managed ETF.

Essentially, active ETFs combine the potential benefits of an ETF structure with those of active management. The idea is to perform better than a benchmark index through flexible active management.

In the past, many fund managers were reticent to offer actively managed ETFs due to potential costs associated with full transparency in the form of daily holdings disclosure (which had historically been required of ETFs).

That's changed to a large extent. After the SEC changed a rule in 2019, allowing some firms to offer actively managed ETFs that are not required to disclose daily holdings, many of these same firms have embraced active ETFs. (Note that you may see these funds referred to as semi-transparent ETFs.) Investors can maintain transparency with access to most recent public holdings and, in some cases, into the fund’s current exposures and drivers of risk and return through daily proxy portfolios.1

The rule change has steadily made actively managed equity ETFs more widely available in the marketplace. Data from Morningstar shows that active ETFs have added nearly $400 billion of inflows over the past 5 years, as of April 2024, suggesting the trend may be in the early innings.

Of course most, if not all, of the risks associated with ETFs also exist for actively managed ETFs (see disclosures for important information on additional risks associated with active ETFs). However, this innovative ETF structure has the potential to allow investors to capture more of the outperformance that active managers seek to provide by mitigating some front-running and trading risks.

The value of research

As part of a fund's management fee, investors pay active managers to conduct company research to identify stocks that might outperform and those that might underperform. Such research decisions have the power to add to shareholder returns.

However, those returns may take time to materialize in trading activity across a suite of funds, as individual managers make investment decisions based on their specific portfolio construction and risk mandates. If these research insights are revealed to the market before the desired investment position can be established, that can erode the potential value.

Flexibility to trade over time may enhance performance

To determine how quickly to build or reduce a position, traders use their expertise to balance the cost of liquidity with the risk of not executing a trade all at once (should market volatility lead to significant price changes). Because mutual funds and ETFs often trade in large volumes, asset managers frequently spread trades out over multiple days to reduce costs.

Disclosing trading activity to the market while positions are still being built or reduced could allow for increased front-running and preclude cost-saving trading strategies, thus leading to lower net performance. Opportunistic or algorithmic trading strategies could reduce trading costs even further for actively managed ETFs that are not required to disclose holdings daily. ETFs that do not need to disclose holdings daily may benefit from the ability to implement trading strategies that preserve more of the potential active management value for shareholders.

Investment implications

The shift to enable some firms to offer ETFs without the requirement to disclose holdings daily may help reduce the potential costs to shareholders associated with full transparency. At the same time, active ETF structures are designed to provide transparency into the funds’ holdings and drivers of performance. And market demand from investors who are seeking the benefits of ETFs and who believe in the potential of active management has clearly shown an appetite for such investments.

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ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

1. Each asset manager has taken a slightly different approach to how they will comply with the disclosure requirements. For example, Fidelity is using a tracking basket and weight overlap disclosure.

Investing involves risk, including risk of loss.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917