Unlocking the Potential of Active ETFs: Four Reasons to Invest Now

And yet, adoption rates are still slow.

Many investors and advisors have not yet pulled the trigger on using active ETFs in their portfolios, which is a shame as the fund vehicle can provide plenty of benefits and help portfolios meet goals. With that in mind, for investors who are holding out on using active ETFs in their portfolios, here are four big reasons to consider them for your investments.

Believe it or not, active ETFs have long been available for investors to use. The first one launched way back in 2008. But it wasn’t until right before the pandemic that active ETFs took off in a meaningful way. The reason came down to a series of rule changes from the SEC.

Because ETFs rely on market makers for their intraday liquidity and keeping their share prices tied to their net asset values, managers are forced to disclose their holdings daily — not typically a big deal for an index fund. We can easily find out what’s inside the S&P 500 or Dow Jones Industrials. But for active management — which can hold anything, in any proportion — this can lead to front running.

The changes at the SEC allowed managers to have different levels of transparency with regard to their holdings. Different solutions have been formed to provide market makers with the information they need while not disclosing underlying holdings. As such, active ETFs have taken off in a big way. This chart from Morningstar shows how active ETFs have grown after the 2019 change.

Source: Morningstar

However, not everybody uses them. Partly, mutual funds could be to blame. Active mutual funds have historically underperformed index funds by a wide margin. This stain could have been unfairly placed on the world of active ETFs. The thing is, active ETFs overcome many of the issues with mutual funds, and there could be four major benefits to using them.

Uncle Sam always seems to have his hand open when it comes to investing, and portfolios pay a variety of different taxes on their gains, dividends and interest income. By and large, you can control taxes. But for investors who hold mutual funds, they’re at the mercy of portfolio managers and other fund holders.

The problem is that investors are on the hook for taxes based on what happens inside a mutual fund. If an active manager sells a stock or bond — even if an investor doesn’t sell their shares of the fund — they get hit with a capital gains distribution and are forced to pay the tax. Tax drag can significantly impact long-term returns. After all, what you keep is just as important as what you make.

Active ETFs are different. This comes down to their structure and creation/redemption mechanism. You and I buy ETFs in the secondary market on exchanges. However, ETFs use something called authorized participants (APs) to create and redeem shares. These APs are willing to take shares of a security when they redeem their ETF shares. This allows active managers to pass off gains out of the ETF and avoid capital gains taxes. Investors in the secondary market only pay gains taxes when they decide to sell the shares.

One of the benefits that passive and index ETF holders have realized is the low costs associated with running an ETF versus a mutual fund. Today you can score index funds costing less than 0.05% in fees. It turns out that it also works for active funds and provides an extra boost.

By removing all fees, most active managers actually do a decent job of beating their benchmarks. However, fees and expenses create a so-called hurdle that managers must clear in order to show that outperformance. If you’re beating your benchmark by 0.50% per year but you’re charging 0.65% to do it, investors will underperform.

The win is that active ETFs charge much lower fees than active mutual funds. Today, investors can buy active ETFs costing as little as 0.15% in expenses. That’s cheaper than some index funds. With lower fee hurdles, active managers can deliver on their promises of better returns. Therefore, investors can actually realize outperformance.

While the SEC rules changes that allowed for new non- and semi-transparent structures to be created could have been the kick-start for active ETF growth, it turns out that most active ETF have adopted transparent structures. In fact, it’s an overwhelming majority. The number of semi-transparent ETFs on the market is less than 100 funds.

This gives active ETFs an advantage over mutual funds without hitting performance. Mutual funds are only required to report their holdings on a quarterly basis. But with active ETFs, investors know exactly what they own each day. Secondly, the issues of front running don’t seem to be a problem and performance hasn’t been hampered.

Finally, active ETFs provide a level of liquidity and flexibility that mutual funds can not touch.

Like passive ETFs, active ETFs can be traded throughout the day. This is in contrast to mutual funds, which can only be bought and sold at end-of-day net asset values. It also allows investors to use active ETFs to take advantage of downswings to buy or tax-lost harvest and plan spending needs, giving them a liquidity edge over mutual funds. Moreover, investors have the ability to sell short, pledge ETFs to securities lending programs and trade options on active ETFs. Finally, active ETFs can be used as collateral for margin portfolios. Not all mutual funds will qualify at every brokerage firm.

All in all, active ETFs provide the best of both worlds. Investors have a chance for outperformance while still realizing many of the benefits of passive ETFs. With lower tax potential and flexibility, using them in a portfolio is quickly becoming a no-brainer.

And with new fund launches nearly every month, investors have plenty of options on how to integrate them into their portfolios. Like with all investments, digging into the holdings and fees is key to making sure you buy the right fund.

These ETFs are sorted by their YTD total returns, which range from -2.7% to 7.8%. They have expense ratios between 0.17% to 0.36% and have assets under management between $5B and $30B. They are currently yielding between 0.8% and 9.7%.

Active ETF growth has been swift. For those investors still on the fence about using them, active ETFs liquidity, low costs and tax savings are wonderful benefits that mutual funds can not touch. With the potential for outperformance, investors should make the switch to active ETFs in their portfolios.