Active ETFs: A New Tool for Financial Advisers

The ETF market reached about $10 trillion in assets globally by the end of 2022, according to BlackRock. Active ETFs are increasingly popular among financial advisers for their flexibility. These funds merge professional management with the benefits of ETFs, enabling real-time responses to market changes.

What Sets Active ETFs Apart Active ETFs depend on portfolio managers for discretionary investment decisions, unlike passive ETFs that simply track indices. This method gives advisers access to strategies typically found in mutual funds, but delivered through a liquid, cost-efficient ETF structure.

Morningstar reports that active ETFs attracted $102 billion in net flows in 2022, marking a 25% increase from the previous year. Their transparent structure, intraday tradability, and growing adoption across asset classes, including equities and fixed income, drive this growth.

“Active ETFs combine the benefits of traditional active management with the liquidity and tax efficiency of an ETF,” said Stephanie Pierce, CEO of Dreyfus, Mellon & ETF Investment Management at BNY Mellon. These features are especially valuable in volatile markets, where quick decision-making is crucial.

Advantages for Advisers and Clients Active ETFs help advisers address diverse client needs. In a low-yield environment, fixed-income active ETFs provide tailored duration and credit risk exposure. Bahl & Gaynor’s Income Growth ETF illustrates this, offering a dividend-focused strategy for retirees seeking income with reduced equity exposure.

Cost transparency is another key advantage. Active ETFs disclose holdings daily, while traditional mutual funds do so quarterly. This allows for precise portfolio adjustments and minimizes surprises. Their typically lower expense ratios enhance cost-effectiveness, although fees can vary based on the strategy.

Liquidity is essential. Active ETFs trade on exchanges like stocks, allowing advisers to implement tactical changes during trading hours instead of waiting for end-of-day mutual fund NAV calculations. “For advisers managing high-net-worth clients, executing trades in real time offers distinct advantages,” noted Michael Lane, Head of iShares U.S. Wealth Advisory at BlackRock.

Challenges and Considerations Despite their benefits, active ETFs face challenges. Some advisers hesitate due to concerns about potential underperformance compared to benchmarks. Daily transparency can foster accountability but may expose high-conviction strategies to front-running by other market participants.

Tax efficiency varies with active strategies. Unlike index ETFs, which generally have lower turnover, active ETFs may frequently realize capital gains. Advisers must evaluate whether these gains align with client tax preferences.

The crowded ETF market complicates the task of distinguishing high-quality active products. As of Q3 2023, the U.S. had over 3,100 ETFs, including nearly 950 active ones, according to CFRA Research. Conducting thorough due diligence on asset managers, performance histories, and embedded risks is essential.

Future Implications The rise of active ETFs mirrors broader market trends. Persistent inflation, demographic shifts toward retirement, and increasing retail investor participation underscore their relevance. Advisers increasingly view them as complementary tools for achieving specific objectives rather than replacements for mutual funds.

The Securities and Exchange Commission (SEC) has fostered innovation in this area. Rule 6c-11, adopted in 2019, eased operational constraints for ETF issuers. This regulatory clarity has enabled semi-transparent active ETFs, which disclose holdings less frequently while maintaining structural advantages. An example is American Century’s Focused Dynamic Growth ETF, designed for long-term capital appreciation with lower disclosure frequency.

Advisers who adopt active ETFs may gain a competitive edge in tailoring solutions to clients’ needs. However, careful selection and ongoing monitoring are crucial. “Introducing active ETFs to client portfolios should be a deliberate process, aligned with risk tolerance and investment goals,” Pierce emphasized.

For financial advisers, understanding and leveraging active ETFs means providing nuanced, data-driven advice. Their emergence broadens the toolkit for navigating today’s complex investment landscape.