Harbor Capital on the Role of Active ETFs in the Current Decade

The 2020s are proving to be a very different market environment than the prior decade.

The current decade has been characterized by high inflation, a quick interest rate hike cycle, deglobalization, and enhanced volatility. This new environment is poised to have profound investment implications.

The current performance of the 60/40 portfolio demonstrates how investment strategies will need to change to capture current opportunities. According to my research, since 2020, the cornerstone 60/40 portfolio has returned considerably less in real returns, Kristof Gleich, president and CIO of Harbor Capital Advisors, said recently.

“We do very much believe that it was the 2010s that was the anomaly, not the 2020s. I think the 2020s are getting back to something like normal,” he said.

“The 2010s was the decade that was the echo coming out of the once-in-a-100-year financial crisis,” Gleich added. “In the 2010s, we had zero interest rates flood the system with liquidity, compressed risk premia, and reflate assets create a positive wealth effect.”

These were all temporary measures to try and create that escape velocity for the U.S. and global economies to avoid this Japanese-style balance sheet recession, Gleich said. The temporary measures, however, lasted much longer than anticipated.

Deglobalization is another key characteristic of the current decade, something that is leading to more volatility in markets. “It’s clear to us that globalization was this unstoppable force throughout the 2000s and 2010s. That’s now definitely paused and is going into reverse,” he noted.

To add to the complications, the U.S. economy has gone through the quickest, most aggressive interest rate hike cycle in 40 years as the Fed tries to rein in inflation.

How This New Era of Investing Impacts Actives

There are a few reasons why this environment may be a better fit for active managers than passive funds.

Gleich said “the tougher the environment gets for market returns, the more opportunity there is to see differentiation between skilled active managers and passive ETFs. Conversely, when market conditions are favorable, those conditions are the dominating feature of the race — not the participants.”

“Unless anything changes significantly… interest rates are going to be materially higher than they’ve been in some time,” he explained. “We know through historical analysis that [higher] interest rate environments tend to be more conducive with active managers adding more alpha.”

Notably, active managers are often better positioned in a higher dispersion environment (individual stocks or sectors). Dispersion has increased in the current decade compared to the last, creating another tailwind for active managers.

During the webinar, Gleich pointed to data that showed more managers are outperforming in the 2020s than during the 2010s. According to Morningstar, actively managed mutual funds and ETFs roared back to life in the first half of 2023.

“We would argue that this trend is set to accelerate,” he said.

Mutual Funds or ETFs: How Investors Can Access Skilled Active Management

One of the biggest trends currently happening in the industry is the growing role of ETFs, according to Gleich.

While exchange traded funds have been around for three decades, there have been recent regulation changes that have enabled the ETF industry to expand and flourish.

Historically, mutual funds were the domain for active management, while ETFs were the domain for passive management. However, the SEC adopted a new rule in 2019 that, most notably, removed regulatory hurdles for asset managers looking to enter the ETF market. The new rule removed the regulatory distinction between index-based and actively managed ETFs.

Gleich said the rule change in 2019 caused a big adjustment in the composition of the ETF marketplace. The new rule spurred a flood of new issuance of active ETFs.

“We think that this decade is going to be the decade where active ETFs really do emerge,” he added.

Active ETFs enable investors to get cheap, quick, efficient exposure to managers, themes, asset classes, or different slices of the market, Gleich said. However, a key advantage of active ETFs is the enhanced transparency and more attractive fee and tax treatment.

For more news, information, and analysis, visit the Market Insights Channel.

Important Information

The views expressed herein may not be reflective of current opinions, are subject to change without prior notice. This material is for informational and illustrative purposes only. This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses.

Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value.

ETFs are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are generally minimized for the holder of the ETF.  An ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying portfolio. However, capital gains tax may be incurred by the investor after the ETF is sold.

A “60/40 portfolio” is guidepost portfolio for a moderate risk investor. Portfolio allocations of 60% to equities to seek capital appreciation and 40% allocation to fixed income help mitigate risk and offer potential income.

Alpha is a measure of risk (beta)-adjusted return.

This article was prepared as Harbor Funds paid sponsorship with VettaFI.

Harbor Capital Advisors, Inc.