Active ETFs: The Best of Both Worlds?

Active ETFs: The Best of Both Worlds?

Now that the fee wars have come to their natural conclusion, fund managers seem to be opening up a new frontier in their efforts to attract investor dollars: Adding active-management oomph to low-cost index options. Vanguard’s decision to open three new active funds solely to clients of its robo-adviser, which we discussed earlier this month, is one such attempt.

But there’s more than one way to skin a cat, and the venerable Sequoia Fund is pointing the way toward another: Turning a popular active fund into an active ETF. Ruane, Cunniff & Goldfarb, the firm that runs the Sequoia Fund, filed this week with the Securities and Exchange Commission to launch an active ETF with a near-identical strategy and the same management.

While active management has long been the preserve of mutual funds, active ETFs are becoming more popular: Earlier this summer, Fidelity launched active ETF versions of several of its ESG funds.

Historically, ETFs have offered a few advantages: They have the low fees of index funds, combined with somewhat higher liquidity than traditional mutual funds. (Mutual funds trade once per day, while shares of ETFs can be bought and sold throughout the trading day on the exchange, with prices adjusting in real time.) And ETFs have certain tax advantages over mutual funds. Unlike with a mutual fund, ETF investors only incur capital gains when they sell their shares in the fund, not when the fund’s portfolio holdings change.

But the returns of a passive index ETF will never surpass its benchmark. Can an active ETF with a manager you believe in offer the best of both worlds?

At Adviser Investments, we’ve long been proponents of active management. We believe a quality active manager can provide value that exceeds their benchmark over time.

But there are caveats. Management fees for active ETFs tend to be higher than those of index ETFs, and they are entirely at the fund provider’s discretion, eroding any inherent benefit. And while it’s true you can trade ETFs more frequently than mutual funds, we don’t think that attribute provides much of an advantage for long-term investors. As we often say, investment success is down to time in the market, not market timing.

  The returns of a passive index ETF will never exceed its benchmark. Can an active ETF with a manager you believe in offer the best of both worlds?

Perhaps our biggest reservation with purchasing an active ETF over a mutual fund with the same strategy and managers has to do with capacity. The advantage of a strong manager over an index is that managers hand select investments while indexes blindly follow their mandates. A manager who commits to investing only in her best ideas is able to generate outperformance. That ability to be choosy about what a fund invests in is particularly important when it comes to funds that invest in small-cap companies or niche sectors, where the performance gap between the best and the rest is largest.

But active ETF managers often have a tougher time exercising that useful discretion than mutual fund managers, because they can’t limit how many shares of their ETF are bought on the exchange.  If a mutual fund manager finds they’re running out of companies they believe in, they can close their fund to new investors. ETFs have no such limitations. When new ETF shares are bought, managers must find ways to deploy those dollars, potentially diluting their ability to be selective in their picks.

Still, capacity is less of a consideration when it comes to funds investing in broader sectors and bigger companies.  All else being equal, if you have conviction in the managers, the active ETF version of a strategy has the potential to deliver greater upside than its mutual fund counterpart.

Older Funds Are Getting Green Facelifts

More and more investors are taking environmental, social and governance (ESG) factors into account when choosing which funds and firms to invest in—and fund companies have taken notice. According to Morningstar, 25 funds have rebranded themselves as “sustainable” or “green” in the last year alone.

Some of those switches appear to be in name only. The Wall Street Journal reported last week that Victory Capital Management’s $1.5 billion USAA Sustainable World Fund—formerly the USAA World Growth Fund—has over $100 million invested in fossil-fuel companies, for example.

In the Sustainable World Fund’s case, a deep dive into the fund’s disclosures reveals that despite the new name, management reserves the right to invest in firms that don’t meet ESG benchmarks, and the fund’s advisers told the Journal it considers them merely one factor among many to be evaluated when selecting investments.

Not all fund companies have taken such a light touch to their portfolios when rebranding their funds: Putnam adjusted 75% of its holdings when turning its Multi-Cap Value fund into its Sustainable Future Fund.

  According to Morningstar, 25 funds have rebranded themselves as “sustainable” or “green” in the last year alone.

But both cases point to something that investors should be wary of. What fund sponsors really mean when they use buzzwords like “sustainability” in a fund’s name is for the fund companies to decide—and may not amount to much more than marketing hyperbole. It’s up to investors to look deeper to determine whether fund companies are putting their money where their mouth is.

Podcast: The Stock Market—Rocket or Rollercoaster?

Eighteen months ago, the pandemic crashed the stock market. Ever since? It seems to do nothing but hit new highs. Is this rocketship market on its way to the moon? Or should we expect a bumpier ride through the rest of the year? Chairman Dan Wiener, Director of Research Jeff DeMaso and Vice President and Portfolio Manager Steve Johnson discuss the remarkable bull run we’ve been on, and whether now is a good time to prepare for the next correction or crash. Topics include:

• How high levels of global liquidity are driving markets up and up
• Whether the delta surge could slam the breaks on economic growth for the rest of the year
• Will the Fed continue to keep interest rates low and for how long
• …and much more

It’s easy to stay invested when markets are going up. It’s much harder when they’re going against you. Listen to our experts now and decide if you—and your portfolio—are ready to handle a bumpier ride to come.

Adviser Investments’ Today’s Market Takeaways

There’s no shortage of hyperbolic headlines and provocative punditry in the financial media. But you won’t find such hysterics here. In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets.

In our most recent Market Takeaways, Vice President Steve Johnson talked about the trading habits of Fed presidents, while Research Analyst Liz Laprade discussed El Salvador’s embrace of bitcoin.

We hope you find these episodes engaging and accessible. If there are any topics you’d like us to address, please send an email to info@adviserinvestments.com!

About Adviser Investments

Adviser Investments is a full service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. We’ve been helping individuals, trusts, institutions and foundations since 1994, and have more than 3,500 clients across the country and over $6 billion in assets under management. Our portfolios encompass actively managed funds, ETFs, socially responsible investments and tactical asset allocation strategies, with particular expertise in Fidelity and Vanguard mutual funds. We take pride in being The Adviser You Can Talk To.

Our minimum account size is $350,000.  To see a full list of our awards and recognitions, click here, and for more information, please visit www.adviserinvestments.com or call 800-492-6868.