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

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

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

Active ETFs saw positive annual inflows from 2019 through 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 see it [active ETFs] as the growth engine of active management,” said Bryan Armour, director 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 cloudy market.”

At a high level, mutual funds and ETFs are similar.

They are legal structures that contain investor assets. But investors have increasingly turned toward ETFs in recent years because of the cost advantages they generally enjoy over mutual funds, experts say.

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

This active management usually costs more than passive investing.

Passive investing, which is used in index funds, doesn’t require as much hands-on work from money managers, which essentially replicate the returns of a market benchmark like the U.S. S&P 500 stock index. Their fees are therefore generally lower.

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

Data shows that active managers tend to underperform their peer index funds over the long term, net of fees.

For example, about 85% of active large-cap mutual funds underperformed the S&P 500 over the past decade. facts from S&P Global.

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

“It’s been a rough 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 – ​​especially in more niche corners of the investment market – active ETFs often have a cost advantage over active mutual funds, experts say.

This is mainly due to lower reimbursements and tax efficiency, experts say.

ETFs generally have lower fund expenses than mutual fund counterparts, and generate annual tax bills for investors with much less frequency, Armor said.

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 in general. The market share of ETFs relative to mutual fund assets has more than doubled over the past decade.

That said, active ETFs represent just 8% of total ETF assets and 35% of annual ETF inflows, Armor said.

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

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

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

Such conversions “can turn the tide of outflows and attract new capital,” the Bank of America note said. “Two years before the conversion, the average fund was $150 [million] at outflow. After conversion, the average fund gained $500 [million] of the inflow.”

That said, there are caveats for investors.

First, investors who want an active ETF are unlikely to have access to one within their workplace retirement plan, Armor said.

ETFs, unlike mutual funds, don’t have the ability to reach new investors, Armor said.

This could put investors in ETFs with certain “super niche, concentrated” investment strategies at a disadvantage because money managers may not be able to execute the strategy as well and the ETF gets more investors, he said.