The future looks bright with Bank of America recently estimating global ETF AUM will reach US$50tn by 2050, with the growth coming at the expense of mutual funds, despite them currently having the lion’s share of global AUM.  

The massive success so far has been built on passive ETFs, with funds tracking well-known indices like FTSE 100, Nasdaq 100 and Euro Stoxx 50 being rapidly adopted by investors who use them as core holdings in their portfolios.

But the price of success has been that many people believe that ETFs are just about passive strategies while the reality is that they are just a wrapper. The focus on passive is starting to change, with ETF investors over the past few years increasingly demanding more types of investment strategies in ETF form.

This most notably includes active strategies. My colleagues at HANetf and I believe that eventually all new funds that have daily liquidity will end up in an ETF wrapper. ETF investors want to be able to add all investment strategies and that has happened over the past five years, with many of the new ETFs being developed moving away from passive.

Active ETFs are probably the next frontier for the European ETF market as what happens in the US tends to follow here in the UK. Typically, the US is three to five years ahead in AUM growth and product innovation. If this is the case, then it’s only a matter of time before active ETFs become commonplace in Europe. Over the past two years active ETFs have gone from nowhere to being the main battleground for providers in the US and we expect that to follow in the UK and Europe.

The move to active and more

Regulators have played a major role in the rise of active ETFs. When the Securities and Exchange Commission (SEC) – the US equivalent of the Financial Conduct Authority –changed its rules around two years ago to allow active ETFs to be issued en masse it opened the floodgates. Active managers are now able to provide minimal holdings disclosure which has made them comfortable to issue ETFs which they had avoided in the past because of the requirement to give full daily disclosure of holdings.

Following the rule change, many traditional mutual fund asset managers rushed to issue. The result is that 2021 is the first year where active ETF new product filings at the SEC have exceeded passive. Providers such as JP Morgan and Dimensional have also converted billions of dollars of mutual fund AUM into ETFs which has added further momentum to the active market.

Independent research and consultancy firm ETFGI estimates assets and net inflows in active ETFs worldwide were US$418bn and US$110bn respectively at the end of September 2021.

According to an ETFGI report, during September 2021:

Actively managed ETFs and exchange-traded products (ETPs) saw net inflows of US$14.68bn, bringing year-to-date net inflows to US$109.93bn. Assets invested in actively managed ETFs and ETPs finished the month up 1.1%, from US$413bn at the end of August to US$418bn. …

Equity-focused actively managed ETFs and ETPs listed globally saw net inflows of US$9.72bn during September, taking net inflows for the year to September 2021 to US$52.73bn compared with US$16.31bn in net inflows equity products in the year to September 2020. Fixed Income focused actively managed ETFs and ETPs listed globally saw net inflows of US$4.33bn in September, taking net inflows for the year to September 2021 to US$45.79bn compared with US$30.74bn in net inflows for fixed income products for the year to September 2020.

Active ETFs are building to be a major part of the ETF market but in Europe, while active ETFs exist, the market is still nascent. American investment management firm PIMCO led the way with a range of bond ETFs, and at HANetf we have issued the world’s first Shariah active global equity ETF and a sustainable ESG global equity active ETF. The latter also is a carbon neutral investment as the carbon impact of the equity holdings is offset.

It’s still early days for active ETFs but watch this space. My prediction is it will be the hottest growth area in two or three years’ time. However, it will mean European regulators having to follow the SEC and allow flexibility to active managers around disclosure.

The ETF attraction

The core attraction for investors is that ETFs are a wrapper to deliver an investment strategy which is effectively the same as a mutual fund. However, the ETF wrapper is an improvement on the mutual fund, similar to how mobile phones improve on landlines and electric cars improve on petrol or diesel vehicles.

ETFs are tradable so an investor can get ‘Amazon Prime’ gratification and buy and sell instantly on a stock exchange as opposed to having to complete a form, attach a cheque and wait a week to get a price. They tend to be cheaper with total expense ratios (TER) as low as 0.02% annually and rarely above 1%, while mutual fund charges range between 1% and 3%. ETFs are also transparent in the assets they hold and can publish the data daily, compared to mutual funds that tend to only disclose holdings monthly (which means it is out of date) and is usually only the top ten holdings.

Long-term investors have benefited, with portfolio costs falling dramatically, enabling them to save 1% in fees annually over decades, which has the effect of multiplying performance considerably. Many academics believe that lower fees are the most effective way to grow investments in the long term.

The growth in ETF and passive investing has shone a light on active managers who stock pick rather than use an index to select investments. They’ve tended to charge higher fees and on average have underperformed the main indices. This has led to many of the worst performers being weeded out and only the active managers who can demonstrate true alpha surviving.

The ETF wrapper has proved itself as cost-effective and ideal for innovation and that is being further demonstrated in areas such as thematic ETFs.

Views expressed in this article are those of the author alone and do not necessarily represent the views of the CISI.