Why exchange-traded funds are a ‘growth engine’ of active management

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Actively managed exchange-traded funds are a growing trend in the investment space.

Until then, investors have been pulling money out of active mutual funds in recent years and looking for actively managed ETFs. Investors withdrew about $2.2 trillion from active mutual funds from 2019 to October 2024, according to Morningstar data. At the same time, they added about $603 billion to active ETFs.

Active ETFs experienced positive annual inflows from 2019 to 2023 and are on track for positive inflows in 2024, according to Morningstar. Meanwhile, active mutual funds lost money in all but one year (2021); They lost $344 billion in the first ten months of 2024.

“We’ll see [active ETFs] as the growth engine of active management,” said Bryan Armour, head of passive strategies research for North America at Morningstar

“It’s still early innings,” he said. “But it was a bright spot in an otherwise gloomy market.”

Overall, mutual funds and ETFs are similar.

These are legal structures that hold investor assets. However, investors have gravitated toward ETFs in recent years because of the cost advantages they generally enjoy compared to mutual funds, experts say.

Why fees are important

Fund managers who use active management actively select stocks, bonds, or other securities that they expect to outperform a market benchmark.

This active management usually costs more than passive investing.

Passive investing, like that used in index funds, doesn't require as much hands-on work from money managers, essentially replicating the returns of a market benchmark like the S&P 500 U.S. stock index. As a result, your fees are usually lower.

According to Morningstar data, active mutual funds and ETFs had an average asset-weighted expense ratio of 0.59% in 2023, compared to 0.11% for index funds.

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Data shows that after accounting for fees, active managers tend to underperform their benchmark index funds over the long term.

About 85% of large-cap active mutual funds underperformed the S&P 500 over the past decade, according to data from S&P Global.

As a result, according to Morningstar, passive funds have attracted more investor money annually over the past nine years than active funds.

“It's been a tough few decades for actively managed mutual funds,” said Jared Woodard, investment and ETF strategist at Bank of America Securities.

But for investors who prefer active management — particularly in more niche areas of the investment market — active ETFs often have a cost advantage over active mutual funds, experts say.

According to experts, this is mainly due to lower fees and tax efficiency.

According to Armor, ETFs generally have lower fund fees than mutual funds and are much less likely to incur annual tax charges for investors.

In 2023, 4% of ETFs distributed capital gains to investors, compared to 65% of mutual funds, he said.

Such cost advantages have helped boost ETFs overall. The market share of ETFs compared to mutual fund assets has more than doubled in the last decade.

However, active ETFs account for only 8% of total ETF assets and 35% of annual ETF inflows, Armor said.

“They represent a tiny portion of active net assets, but are growing rapidly at a time when active mutual funds have seen fairly significant outflows,” he said. “So it’s a big story.”

Conversion of mutual funds into ETFs

In fact, many asset managers have converted their active mutual funds into ETFs, following a 2019 Securities and Exchange Commission rule that allowed such activity, experts said.

To date, 121 active mutual funds have become active ETFs, according to a Nov. 18 research note from Bank of America Securities.

Such conversions “can stem outflows and attract new capital,” Bank of America said in the statement. “Two years before the transition, the average fund was $150 [million] in drains. After conversion, the average fund made a profit of $500 [million] the tributaries.”

However, there are reservations for investors.

For one thing, investors who want an active ETF may not have access to it as part of their company pension plan, Armor said.

Unlike mutual funds, ETFs are unable to attract new investors, Armor said.

This could disadvantage investors in ETFs with certain “super-niche concentration” investment strategies because asset managers may not be able to implement the strategy as the ETF attracts more investors, he said.