Global Head of ETF Solutions,
Head of ETF Solutions, North America, State Street
Head of ETF Servicing, Europe,
Head of ETF Servicing, APAC,
This increase in popularity of actively managed ETFs can be explained by changing supply and demand dynamics. Looking ahead, we expect these dynamics to not only remain constant, but also accelerate the growth and innovation of actively managed ETFs.
Changing regulations have unleashed supply
While the first active ETF was launched in 2008 in the United States, it was slow to take off as active ETFs were required to file for exemptive relief from some provisions of the Investment Act of 1940. This process could be both time-consuming and expensive, slowing the ability to launch and driving up breakeven thresholds. The Securities and Exchange Commission (SEC) first began considering new rules to modernize the regulation of ETFs in 2008, but the effort was tabled during the Global Financial Crisis. Efforts to launch ETFs with the same holdings disclosure as mutual funds began around the same time.
Rule 6c-11, or the ETF Rule, codified the exemptive relief process for ETFs that followed the provisions of the rule. This expedited the time to launch from several years to 60 days. As a result, legal costs were significantly reduced. Since the enactment of Rule 6c-11 in 2019, active ETFs exploded in number, growing from 325 to 1,071 funds in the US alone. In other words, it took 11 years for active managers to launch 325 ETFs before the rule, and a little over three years to launch close to 750 more.
Another regulatory change allowed ETFs to either reveal their portfolios less frequently, or mask their true holdings using a representative set of securities known as a proxy. This created an avenue for active managers to launch ETFs and allowed new managers to enter the ETF marketplace that previously had frontrunning/free-riding concerns.
These changes in regulations led to many active mutual fund providers converting or creating “close cousins” of their existing active mutual fund strategies or adding new strategies to active ETFs. According to our data, about 46 actively managed mutual funds have been converted into ETFs since early 2021, and another 16 have been announced for 2023.
Changing rules made it easier to bring an active ETF to market while also enabling other asset managers to keep their “secret sauce”. As a result, by the end of 2022, the number of asset managers with active ETFs had quadrupled since the end of 2017, according to data from Morningstar.
Other countries have followed suit. Canada leads the active ETF market in terms of adoption. As of March 31, active ETFs account for over 27 percent of the overall ETF assets under management (AUM) in Canada. Canada has some of the most ETF-friendly regulations, including:
This regulatory flexibility provides managers greater confidentiality about their strategies and options to enter the ETF market.
In 2015, Australia became the first Asia Pacific (APAC) regional market to allow actively managed ETFs. As of March 2023, active ETFs account for 18 percent of the total Australian ETF market, up from seven percent, five years ago. This shift has been driven by managers converting existing listed investment companies (LIC) into ETFs, as well as a flurry of new listings. It has also been fueled by the innovative dual access model now available to managers listing ETFs in Australia. The dual access structure enables active managers to run a single register for both unlisted and listed investments. As a result, managers can gain greater operational and investment efficiencies, and investors now have more options for accessing their preferred fund. The practice of adding an ETF share class to an existing fund structure is gaining popularity in the Australian market.
Active ETFs are also gaining popularity in the rest of the APAC region. For instance, South Korea launched its first active fixed-income ETF in 2017 and expanded to equities in 2020. There are now 118 active ETFs, making close to 18 percent of the overall South Korean ETF marketplace. Similarly, China approved the first active ETFs for launch in 2020, and there are now 32 products making close to nine percent of China’s ETF market. Both the Tokyo Stock Exchange and the Singapore Stock Exchange expect rule changes offering the ability to launch active ETFs in their respective countries in 2023.
Active ETFs are now the fastest-growing area in Europe. According to ETFGI, an ETF research firm, in March 2023, there were about 89 active ETFs in Europe with US$25.9 billion AUM. Initial concerns by some active managers around publishing their holdings on a daily basis have now dissipated, and the market is seeing traditional mutual fund managers enter the ETF arena with active strategies typically only seen in mutual funds. Recent comments from the European Union financial services chief, favoring a ban on inducements or commissions to banks, broker/dealers, platforms and advisors as an incentive for the sale of mutual funds, could be a catalyst for active ETFs in the region. Such a ban would level the playing field, as ETFs do not offer such retrocession payments. The long-awaited retail investment strategy was published on May 24 and although not a full ban on inducements it introduces restrictions, safeguards and increased transparency requirements. The European market is also seeing an increase in the availability of active ETFs on platforms, making the products more widely available to the relatively untapped retail market, which is seeing huge growth in Europe post-COVID-19.
Investor demand is driving change
Active ETFs have gained significant traction among investors as they combine the best of both worlds – the inherent efficiencies of the ETF structure and the alpha-generating capabilities that active management can bring. According to Factset, investors in particular favored low-cost equity and fixed-income ETFs in 2022. Nearly 80 percent of all cash flows went into ETFs with expense ratios below the 44 basis points (bps) industry average. The average fee for an actively managed equity ETF reduced to 0.38 percent, less than half of the 2019 level. Active fixed-income ETFs followed suit, at 0.37 percent. If fee compression continues, FactSet expects active equity ETF fees to come down to 0.31 percent by end of 2023.
Another benefit of active ETFs in certain jurisdictions is tax efficiency. Mutual fund investors who invest outside of tax-exempt structures face adverse tax treatment in the US. They must not only pay capital gains tax when they exit a position, but are also taxed when their fund is forced to sell winning positions because other investors have exited. ETFs can redeem securities in-kind, minimizing the need to sell securities in order to meet investor redemptions. This can reduce the amount of capital gains realized by the fund, thereby reducing the tax burden for investors. Due to a quirk in their structure, ETFs are largely immune to this latter element. Researchers at the Wharton School of Business at the University of Pennsylvania have found that demand for ETFs is being driven primarily by tax considerations.1
ETFs provide investors with greater flexibility than mutual funds to buy and sell a low-cost security, replicating a broad portfolio of stocks at negotiated prices throughout the trading day. Active ETFs expand on this flexibility by offering broader investment choices than currently available to active mutual funds. This can help investors capitalize on an emerging market trend, or react to an adverse market event swiftly, and potentially generate higher returns. This is not to say that active ETFs can eliminate the underlying risk of equity or bond markets. However, they may enable investors to find solutions that better suit their personal preferences when investing in capital markets – including both equities and fixed income. With rising inflation and rate hikes, markets are expected to remain volatile for the near-term. Active ETFs could provide the necessary flexibility and diversification that investors are looking for in the current volatile investment environment.
Accelerating growth and innovation of actively managed ETFs
Actively managed ETFs are still only a fraction of the expanding ETF universe. According to ETFGI, active ETFs account for only 5.5 percent of the almost US$10 trillion global ETF market. Active ETFs’ growth in double digits has only occurred in the past few years. This leaves plenty of room for the category to expand, with some analysts projecting nearly eightfold growth over the next five years to US$3 trillion.2
We expect growth to accelerate driven by regional expansion. For example, active ETFs make up less than two percent of the European ETF market, yet are the fastest growing segment of the market in 2023. According to our recent report, ETFs 2023 Outlook, there are a number of regulatory changes that will drive the growth of ETFs in the European market this year.
Additionally, asset diversification should drive active ETF growth. In 2017, the majority of active ETFs were held as bond funds. In 2022, equity funds became dominant.3 Active fixed income ETF managers could experience outsized inflows, with the added advantage of being nimbler to swap out bonds as rates change. The innovation of single bond ETFs and more precise targeted strategies will be an accelerant to growth as investors look to the liquidity of the ETF vehicle to gain easier access to the less liquid fixed income marketplace.
Finally, innovation around structures and themes will continue. The growing popularity of sustainable investing, cryptocurrencies, the bio revolution and more could be potential growth drivers for active ETFs. Technology also has the potential to further accelerate innovation in the active ETF space. For example, the use of artificial intelligence and machine learning could enable asset managers to develop sophisticated investment strategies that are better able to adapt to changing market conditions.4