Exchange Traded Funds as a 'Growth Engine' for Active Management

Actively managed exchange-traded funds (ETFs) have emerged as a growing trend in the investment world, attracting attention from investors seeking alternatives to traditional active mutual funds. Over recent years, there has been a noticeable shift in investor behavior, with significant capital flowing out of active mutual funds and into actively managed ETFs.

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Between 2019 and October 2024, investors withdrew approximately $2.2 trillion from active mutual funds while allocating about $603 billion to active ETFs, according to Morningstar data. Active ETFs have consistently posted positive annual inflows from 2019 through 2023 and are on track for another positive year in 2024. In contrast, active mutual funds experienced net outflows in every year except 2021, losing $344 billion in just the first ten months of 2024.

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Bryan Armour, Morningstar’s director of passive strategies research for North America, views actively managed ETFs as a critical growth driver for active management. “It’s still in the early innings,” Armour said, noting the bright prospects for active ETFs despite a challenging broader market environment.

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Mutual funds and ETFs share similarities as legal structures that hold investors’ assets, but ETFs have gained favor due to their cost advantages.

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Active management involves selecting specific stocks, bonds, or securities in an effort to outperform market benchmarks, which makes it more expensive compared to passive investing. Passive strategies, commonly used in index funds, simply replicate market benchmarks like the S&P 500 and incur lower management fees.

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In 2023, the average asset-weighted expense ratio for active mutual funds and ETFs was 0.59%, compared to just 0.11% for index funds, Morningstar data shows. High fees and underperformance relative to benchmarks have been a consistent challenge for active management. For instance, 85% of large-cap active mutual funds underperformed the S&P 500 over the past decade, according to S&P Global data.

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This consistent underperformance has led to passive funds attracting more investor money than active funds for nine consecutive years, further underscoring the challenges faced by active mutual funds. Jared Woodard, an investment strategist at Bank of America Securities, described the trend as part of a “rough couple of decades for actively managed mutual funds.”

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For investors who prefer active management, particularly in specialized investment markets, actively managed ETFs often offer a more cost-effective option compared to mutual funds.

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The advantages of ETFs primarily stem from lower fees and greater tax efficiency. ETFs generally carry lower expense ratios than mutual funds and are less likely to generate annual taxable events for investors. In 2023, only 4% of ETFs distributed capital gains to investors, compared to 65% of mutual funds, according to Armour.

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These cost benefits have helped ETFs expand their market share relative to mutual funds. Over the past decade, the ETF market share of total fund assets has more than doubled. However, actively managed ETFs still represent a relatively small portion of the overall ETF market, accounting for just 8% of ETF assets and 35% of annual ETF inflows, Armour noted.

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“They remain a tiny fraction of active net assets but are growing rapidly at a time when active mutual funds have experienced substantial outflows,” he added.

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To capitalize on the growing popularity of ETFs, many fund managers have converted their active mutual funds into ETFs. This trend gained momentum following a 2019 Securities and Exchange Commission (SEC) rule that facilitated such conversions.

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Since the rule change, 121 active mutual funds have transitioned into ETFs, according to a Bank of America Securities research note. The benefits of these conversions are evident. On average, funds undergoing this transition reversed their fortunes: two years before converting, they saw $150 million in outflows, but after converting, they attracted $500 million in inflows.

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Conversions not only help stem the tide of outflows but also position funds to attract new capital.

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Despite their advantages, active ETFs may not be suitable for all investors. For instance, workplace retirement plans often do not include active ETFs, limiting access for some.

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Additionally, unlike mutual funds, ETFs cannot close to new investors. This inability to limit inflows could become problematic for ETFs pursuing highly specialized or concentrated investment strategies. As an ETF grows, its manager may face challenges in effectively executing the strategy, potentially impacting performance.

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Actively managed ETFs are rapidly gaining traction, offering investors a lower-cost, tax-efficient alternative to active mutual funds. Although they represent a small slice of the ETF market today, their growth underscores the changing dynamics of active management.

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As investors continue to favor ETFs for their flexibility and cost advantages, the momentum behind actively managed ETFs is likely to persist, making them a vital part of the evolving investment landscape.

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