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A Perfect Pairing?

Scott Kefer, CFA 28-May-2024

wine glass and cheese

Exchange-traded funds (ETFs), which debuted in the 1990s as the next iteration of pooled investment vehicles, were initially viewed strictly as passive investments. Initially, these were index-trackers, with potential benefits that included low relative costs, tax efficiency, and the ability to trade intra-day on an exchange, like traditional publicly traded stocks. But the ETF universe has matured—big time—and we think for the better.


Investors have clearly embraced the ETF structure, with the global ETF market ballooning to an estimated $11.7 trillion in AUM*, as of early 2024. Part of this explosive growth reflects the evolution of the types of strategies now offered in ETF wrappers. Previously, ETFs gained some additional traction through the innovation of “smart-beta” or “strategic-beta” strategies. Typically, these investments also tracked an index, but often there was a twist in how the index was constructed. Many focused on certain investment factors—momentum or value or low-volatility, as just a few examples—in an effort to isolate specific investment characteristics and, ultimately, to outperform a traditional benchmark index. Smart beta ETFs garnered substantial interest as these investments seemed to bridge the gap between active and passive investing.


But the evolution didn’t stop there. Circa 2010, active managers began rolling out various actively managed strategies in ETF vehicles. This continues today across fixed income, equity and alternative asset classes.


From our view, the pairing of active management and ETFs is a trend that makes sense and is likely to continue. Investors who want to complement their passive investments with actively managed portfolios have increasing opportunities to do so, while also taking advantage of the liquidity, low-cost potential, transparency, and tax-efficiencies inherent to the ETF investment structure.


Why Active?


Let’s face it, there are times when both fixed income and equity markets are inefficient, sometimes mispricing future earnings or otherwise over/underestimating certain risks. This can be the result of different sources of information, different investment philosophies, or varying investment time horizons or objectives. As a result, we believe there is abundant opportunity for skilled active managers who have a demonstrable edge in selecting securities to build portfolios that differ from their benchmarks. This is how professional investors endeavor to generate alpha, which is a fancy way of saying excess returns above and beyond the benchmark. 


Today, investors can marry the ability to access active fundamental management via an increasing number of ETFs. This offers an intriguing array of potential benefits. For example, capital gains distributions are the bane of many investors at year-end. While ETFs cannot guarantee tax efficiency or avoid all capital gains, there are underlying mechanisms that help minimize capital gains, such as the in-kind share creation and redemption process. Thus, when investors pull money from an ETF, they sell their shares on the exchange rather than from the fund itself. As a result, the ETFs do not have to sell underlying positions to generate cash for redemptions, potentially avoiding gains from those transactions that they would otherwise have to pass on to investors (in a traditional mutual fund structure).


ETFs also eliminate certain expenses germane to some mutual funds. Transparency of holdings is another benefit. With mutual funds there is often a lag before investors know what securities are held in the portfolio, but with ETFs that information is available to investors on a daily basis. And finally, some investors (more like traders) enjoy the ability to buy and sell ETFs intraday, though that’s less of a factor for most long-term investors. 


The Four ‘P’s


As active ETFs proliferate, it’s important that investors do their due diligence to avoid the potential pitfalls. We like to cite the Four ‘P’s of manager due diligence: people, philosophy, process, and performance. Chasing past returns is usually a big area of danger for investors, regardless of whether a fund is active or passive. Fees are also important to watch. One should expect to pay more for active strategies, even in an ETF, compared to passive. Fees should be appropriate to the manager’s process for the asset class, and for the expected excess return potential. Active strategies are generally not market-cap weighted, so paying attention to the liquidity of the portfolio is also important. Liquidity will dictate things such as an ETF’s bid/ask spread when buying shares on the public exchange, which should be considered as part of the cost of owning the fund. The more liquid the ETF, the tighter the bid/ask spread tends to be.


The Continuing Evolution


As we’ve pointed out, ETFs were historically dominated by passive index-oriented strategies, but today investors have access to a growing array of actively managed investment products in what many consider to be an efficient and investor-friendly structure. Make no mistake, however, mutual funds can and will continue to play a very important role in investor portfolios. For example, there are times where transparency may actually be a negative and thus more appropriate for a mutual fund structure. Also, for tax-exempt accounts, such as 401(k)s and 529 Plans, ETFs’ tax efficiency becomes moot. Nevertheless, the proliferation of actively managed ETFs is a good thing for investors, in our opinion.



*According to investment research from Zack’s and published at$11.7-trillion:-whats-driving-the-surge