The Growing Role of Exchange-Traded Funds in Active Management

Investors have been shifting their money from active mutual funds to actively managed exchange-traded funds (ETFs) in recent years. This change has been fueled by the cost advantages of ETFs, such as lower investment fees and greater tax efficiencies, according to experts.

From 2019 to October 2024, investors pulled about $2.2 trillion from active mutual funds, while adding around $603 billion to active ETFs, as reported by Morningstar. Active ETFs have seen positive annual inflows from 2019 to 2023 and are expected to continue this trend in 2024. Meanwhile, active mutual funds have experienced losses in most years, shedding $344 billion in the first 10 months of 2024.

Bryan Armour, the director of passive strategies research for North America at Morningstar, described active ETFs as the “growth engine of active management.” He noted that while it’s still early days, active ETFs have shown promise in what has been a challenging market landscape.

The difference between mutual funds and ETFs lies in their cost structures. Active management requires more hands-on work from fund managers, leading to higher fees compared to index funds, which follow market benchmarks like the S&P 500. On average, active mutual funds and ETFs had an expense ratio of 0.59% in 2023, while index funds averaged 0.11%.

Data shows that active managers often underperform their peers in index funds over the long term, after accounting for fees. About 85% of large-cap active mutual funds lagged behind the S&P 500 over the past decade, highlighting the challenge for active management. As a result, passive funds have been attracting more investor money for the past nine years.

Despite these challenges, active ETFs offer a cost advantage over active mutual funds, especially in niche areas of the investment market. Lower fees and better tax efficiency make active ETFs an attractive option for investors seeking active management strategies.

Overall, ETFs have gained market share relative to mutual funds over the past decade, thanks to their cost advantages. While active ETFs represent a small portion of overall ETF assets, they have been growing rapidly amid significant outflows from active mutual funds.

Many money managers have converted their active mutual funds into ETFs following a 2019 rule change from the Securities and Exchange Commission. This conversion has helped to attract new capital and stem the outflows experienced by mutual funds.

However, there are some caveats for investors considering active ETFs. These funds may not be available within workplace retirement plans, and there may be limitations related to the execution of specific investment strategies as the ETF grows in size.

In conclusion, active ETFs have emerged as a promising trend in the investment space, offering investors a cost-effective alternative to traditional active mutual funds. While there are some considerations to keep in mind, the growth of active ETFs reflects a shifting landscape in the world of finance and investment.