Managers sharpen focus of active ETFs, gain flows

With some exceptions, the largest actively managed equity exchanged-traded funds have taken on the attributes of index ETFs: broadly diversified portfolios that fit neatly into a global asset allocation model.

Many of those offerings, launched over the last few years from primarily Dimensional Fund Advisors LP and American Century Investments' Avantis Investors, had a running start with high brand recognition or widely known executives.

Where active equity ETFs are venturing now, however, is down the more challenging path blazed by ARK Investment Management LLC. ARK's high-conviction, high-visibility approach drove outsized returns (and drawdowns) and flows into and out of the flagship $7.7 billion ARK Innovation ETF, or ARKK. The fund itself was so volatile that another ETF issuer, AXS Investments LLC, launched a daily inverse ETF on ARKK.

Among those taking this more focused approach to active ETFs are Capital Group, T. Rowe Price Group Inc., and other traditionally active fund brands. As active mutual funds continue to see outflows, the specific challenge for active equity ETF issuers is to show that high-conviction, bottoms-up, risk-managed ETFs have a place in institutional portfolios alongside, or even replacing, hedge fund or activist strategies with higher management and performance fees.

Todd Sohn, managing director, ETF and technical strategy for Strategas Securities LLC in New York, has spent years looking at active ETF offerings. "What problem is being addressed and where can active management add value?" Mr. Sohn said. And at what cost? "Most of the largest active equity funds all have expense ratios between 20 and 40 basis points," he said.

Through May 31, U.S.-listed active equity ETFs saw net inflows of $30 billion and total assets hit $199.4 billion across 510 products, excluding leveraged and inverse funds. Total flows into active equity ETFs in 2022 were $68 billion, according to CFRA Research.

Except for a handful of ETFs launched in conjunction with large institutions, most ETFs build an asset base through retail and intermediary adoption and reach the institutional market only after establishing a track record and asset level that passes muster with boards and investment committees. Those track records are still being built: 301, or 59%, of active equity ETFs tracked by CFRA were launched after 2020.

"We are seeing growing comfort by active managers to offer their solutions in the more transparent, tax efficient ETF wrapper," said Bryan Armour, director of passive strategies research for Morningstar Inc. in Chicago.

Roughly 15 months after their February 2022 launch, Capital Group's five active equity ETFs hold $7.7 billion in assets and between 54 and 135 stocks, according to CFRA. Capital Group's initial products adopted full daily portfolio transparency, even as the industry spent more than a decade debating varying forms of proxy or shielded portfolios within the ETF structure.

Current active equity ETFs from T. Rowe Price use a proxy portfolio system designed not only to protect proprietary security selection, but also to insulate investors across the other products managed by the same portfolio managers, said Tim Coyne, global head of ETFs for T. Rowe Price in New York. Those five products, launched in 2020 and 2021, have gathered just under $800 million in assets.

The proxy portfolio essentially shields daily moves in and out of the ETFs on the margin that would otherwise be revealed in a fully transparent model. Such transparency is believed to put price pressure on stocks that may be more specific to that strategy in terms of weight or selection and that may be shared across fund structures and other managed accounts.

The next five products from T. Rowe Price, however, will be fully transparent, focused equity ETFs, according to a recent SEC filing.

"Client preference is evolving," Mr. Coyne said.

Fidelity Investments also uses a portfolio shielding methodology for nine active ETFs. Total assets in the products are $725 million, according to CFRA, including the $386 million Fidelity Blue Chip Growth ETF.

Since late 2021, Harbor Capital Advisors LLC has introduced six active equity ETFs, several with focused holdings of under 50 securities as well as an active small-cap fund with 250 positions, launched at the end of April. Collectively, the funds have $335 million in assets under management, according to CFRA.

Small-cap, transparent active is somewhat of a final frontier for high-conviction offerings. Unlike mutual funds, which can close share issuance to restrict the amount of capital to be invested, ETFs are compelled to stay open in order to keep their share price and NAV in line. This makes under-indexed or low float small caps a challenge for daily, transparent ETFs.

"Active risk management is hard to index, especially in sectors where there is a high dispersion of winners and losers," said Maurits Pot, founder and CEO at Tema Global Ltd. in New York.

In early May, Tema Global launched three, highly concentrated thematic ETFs. For example, Tema's Monopolies and Oligopolies ETF has only 33 positions, managed for 0.75%. The product is an active take on the $8.7 billion VanEck Morningstar Wide Moat Index ETF (MOAT). The VanEck ETF, which has 50 positions and a 0.46% expense ratio, has delivered an annualized return of 13.53% through 10 years ending April 30, compared to 12.2% for the S&P 500, according to VanEck Associates Corp.

"High-conviction strategies seem intuitive for investors, but higher active risk doesn't have to come with higher fees," Morningstar's Mr. Armour said. "Diversification adds value regardless of strategy and tends to come with a cheaper price tag."