Active ETFs are gaining traction. But advisors control the lion’s share of institutional assets for now.
The $1.3 trillion nonadvisor institutional channels — insurance accounts, state and local defined benefit plans, and endowments — have in them represents just 4.2% of the $31 trillion in all professionally managed channels.
According to a recent Cerulli report, titled the “U.S. Exchange-Traded Fund Markets 2023: Product Development Opportunities for a Maturing Structure,” that “represents an opportunity. That’s why almost all (95%) of ETF issuers are “reporting existing or planned [active fund]product development” in anticipation of the opportunities in other institutional areas.
The report, written by Daniil Shapiro, Brendan Powers, and Sally Jin, said fund companies are considering both converting existing active mutual funds to ETFs and following the “dual share-class structure used by Vanguard.”
Risks With Vanguard’s ETF Share Class Structure
There is some risk in the Vanguard dual class structure. And some in the industry are unsure if the SEC will approve it for other funds. A Morningstar article earlier this year by Daniel Sotiroff explained that, in certain situations, ETF shareholders may not receive the tax benefits they expect from an ETF cloned from a mutual fund that has embedded gains.
For example, the Vanguard Extended Duration Treasury Index fund (VEDTX), which includes the Vanguard Extended Duration Treasury ETF (EDV) as its ETF share class, doled out a big distribution to its ETF shareholders in 2009. Assets (long-term U.S. Treasuries) in the mutual fund appreciated in 2008, then investors sold in late 2008 and early 2009.
However, the ETF didn’t take in much money to purge the gains. All of that forced the fund to sell bonds with big gains and distribute them proportionately to the ETF shareholders.
That hasn’t happened to a Vanguard fund since, but it remains a possibility. Also, the likelihood that it could happen with an active fund with a narrow portfolio that is not taking in assets may be higher.
Another issue is the fact that successful active managers sometimes have to close funds to new assets to avoid suffering what Morningstar’s Russ Kinnell has called asset bloat — being so big that they move the prices of the stocks they want to trade. But “ETFs don’t possess a mechanism to prevent new money from entering,” wrote Sotiroff.
Conversions Are Another Option
A fund company doesn’t have to use the dual structure, however; it can just convert a fund to an ETF. The Cerulli report says that 36% of issuers report plans to convert one or more mutual funds to ETFs or transparent active ETFs in the next year. Roughly $73 billion in assets in the U.S. have been converted from mutual funds into ETFs. However, only Dimensional and JP Morgan “have gathered scaled success with this approach” so far.
Shapiro mentioned that other disincentives to convert are losing 401(k) business and lowering fees. “ETF buyers are fee-sensitive,” said Shapiro. And fractional share trading hasn’t become popular enough to penetrate the 401(k) market.
Another issue for institutional use is that ‘an institution doesn’t want to be the majority shareholder of an ETF,’ said Shapiro.
Still, the report also notes that more than half (57%) of firms say U.S. taxable fixed income is a primary product development focus. For all the disincentives, ETFs have become the investment vehicle of choice at least for financial advisors. “Mutual funds are sold; ETFs are bought,” he said.
Why Active ETFs Are Gaining Ground
Ben Johnson, head of client solutions at Chicago-based fund researcher Morningstar, cited a number of reasons for the increasing popularity of active ETFs.
First, he noted the tax benefits of the ETF structure: “While most of the largest ETFs aren’t distributing a penny [in capital gains], 2023 is another year where many mutual funds will leave a large lump of coal in investors’ Christmas stockings [in taxable accounts].”
There’s also fee efficiency. “What you see is what you pay, and it’s generally a lot less with ETFs compared to mutual funds,” said Johnson. “[Mutual funds have] a CVS style receipt including a management fee, a 12b1 fee, transfer agency fees, and some with an advisor fee; the ETF fee, by contrast, is tidier and lower.”
Third, nontransparency, sometimes viewed as a hinderance to active managers in an ETF format, is “a solution in search of a problem.” (ETFs must make their holdings transparent every day, and some active managers view this dimly, though there are nontransparent solutions.)
Johnson said he didn’t want to be dismissive of transparency concerns. He cited material moves in response to trades made by ETFs including shares in Virgin Galactic spiking in response to ARK filing for a space-themed ETF. But he doesn’t think transparency should hold fund companies back from the ETF format.
Also, fund selectors and gatekeepers prefer transparency because they can only hedge risk if they’re able to look into a portfolio. Semitransparent products are also less tax efficient because they’re not able to use custom baskets.
Shapiro noted in his conversation with VettaFi that 59% of issuers are targeting transparent active ETFs. That’s where “all the focus is right now,” he said.
Active ETFs’ Dominance Has Some Caveats
Johnson said nearly three-fourths of new ETFs issued this year so far are active. That supports the findings of the Cerulli study that active ETFs are becoming more popular. However, “a lot [of new ETFs]are active in name only,” he said. For example, Dimensional and Avantis funds are factor based; defined outcome funds, such as those issued by Innovator and First Trust, are also rules-based.
The Cerulli report saw the derivative category at risk, despite the success of the JPMorgan Premium Income ETF (JEPI). “Performance has lagged rising markets and income may be easier to come by with higher rates [quelling demand for defined outcome and other derivative ETFs],” according to the report.
As of December 12, Johnson said Dimensional, JP Morgan, Avantis, and Capital Group were the largest issuers of active ETFs. The four of them account for nearly 60% of newly issued funds.
Still, for all of active ETFs’ recent success, penetration into institutional markets is weak. “More than 80% of [active ETF]assets are now sourced from retail as opposed to institutional clients,” according to the Cerulli report.
Public and private defined benefit plans account for a low-single-digit percentage of active ETF assets. The biggest hope among issuers of new funds is the insurance segment. That’s where use of active ETFs in insurers’ general accounts could gain traction. More than half (55%) of issuers expect active ETF use to increase in such accounts over the next year.
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