The Active ETF Boom: Are They Truly Active?

However, investors may not be getting everything they bargained for.

It turns out that not all active ETFs are genuinely active. Old-school stock and bond picking, which most investors think they are getting with an active fund, aren’t actually what they are receiving. It turns out many active funds are just smart-beta or factor ETFs in disguise. While that may not sway growth or adoption, it is worth considering.

Active ETFs debuted in 2010, but it wasn’t until recently that the number of active ETFs on the market took off. The reasons have been vast. Many of these came from the new SEC regulation, dubbed rule 6c-11.

With 6c-11, asset managers were able to explore new structures for transparency to avoid front-running. This introduced a host of new semi- and non-transparent structures that kept holdings “secret” and allowed asset managers to feel comfortable using the ETF structure for active management.

Since then, active managers have launched 100% brand new funds, created copycat fund launches of existing mutual funds, and conducted mutual fund-to-ETF conversions to go from a small handful of active ETFs in 2010 to just under 1,765 at the end of 2024. This chart from a recent Morningstar collective of articles shows the sheer number of launches since 2010.

Source: Morningstar

Now, with Vanguard’s patent expiring, which allowed ETFs to be shared classes of an existing mutual fund, the growth of active ETFs is set to eclipse passive funds and take more of the lion’s share of assets.

All of this growth is wonderful for advisors and investors. The ETF structure can bring out the best in managers by reducing taxes, eliminating cash drag, and lowering costs in a portfolio. As such, many active ETFs have serious potential to outperform their passive peers and benchmarks.

The issue is that investors may not be buying what they think they are. That’s the gist of some new Morningstar data.

If you had to define active management, you could describe something akin to an analyst or team of analysts combing through market data, financial reports, and charts to find the best stocks or bonds within a given sector. As an investor, you are placing your hard-earned dollars on their skill at finding these opportunities.

Many active ETFs — including some very large and popular ones — actually fall under systematic strategies.

A systematic strategy is taking an index and applying small active massages to the benchmark. This can include applying value screens, looking for strong balance sheets, or scoring momentum and dividend yields. Managers use these systematic elements to purchase stocks or bonds to tweak an index.

And the amount of cash in these systematic strategies is surging. J.P. Morgan, Avantis, Dimensional Fund Advisors (DFA), Fidelity and many others now use systematic strategies in their ETFs. DFA and Avantis control about one-fourth of all active ETF assets and exclusively use systematic strategies in their funds. ¹

If the concept of systematic strategies sounds familiar, it should.

Before active ETFs took off, smart-beta was the king of the castle. If you remember, smart-beta or factor investing took a benchmark index and applied various screens — such as value, looking for strong balance sheets, scoring momentum, and dividend yields — to create a new index of stocks or bonds. The idea was that the indexing took over after the active manager provided the fundamental guide rails.

That’s a slight distinction between smart-beta and systematic strategies. Is there any hand-holding after the initial creation?

The extra hand-holding may not matter.

Looking at the Dimensional U.S. Core Equity 2 ETF (DFAC), which is a massive $34 billion active ETF. The fund’s managers apply value factors to the Russell 3000 to come up with its portfolio. Morningstar shows that DFAC holds 2,664 stocks … basically, the entire index. As a result, DFAC’s returns have been significantly correlated to broader low-cost passive vehicles like the Vanguard Total Stock (VTI) or iShares Russell 3000 ETF (IWV).

For investors, the growth of systematic strategies is just one more thing they need to look at when selecting an ETF for their portfolio. Are you looking for a fully active experience or are you okay with someone just tweaking an index? If you are okay with the second concept, ask if the tweaking is worth it. Is there any extra alpha or value to buying the active ETF versus an already existing smart-beta or passive product on the market?

The answer is a personal one. But in general, a simple strategy tends to work best in a portfolio over the long haul. Advisors and investors may find that when comparing an active fund using systematic strategies to a passive benchmark, it may hold water. But that may not be the case versus a cheaper smart-beat ETF in the same category.

Arguably, the hardest part is finding true active vs. systematic ETFs. Right now, no screener has a way to filter funds based on this preference within the active space. So, investors need to read a prospectus and do some digging.

These ETFs are sorted by their 1-year total returns, which range from 1.4% to 22.1%. They have expense ratios between 0.17% and 0.36% and assets under management between $11B and $38B. They are currently yielding between 1.2% and 9.7%.

There’s nothing necessarily wrong with systematic strategy ETFs, and they can have a place in a portfolio. But investors thinking they are getting one thing — a fully active stock picker — while getting another is a different story. It’s here that more due diligence is needed from financial advisors and investors. Particularly, now that these sorts of funds are driving growth in active ETFs.

When is an active ETF, not an active ETF? When it potentially uses a systematic strategy. As these ETFs grow in size, investors looking for actual active stock or bond picking need to be careful they are getting what they want.

¹ Morningstar (Updated November 2024). Will Active ETFs Outnumber Passive ETFs?