While one active ETF after another enters the market, various Dutch banks have yet to add these to their offerings, and pension funds are still adopting a wait-and-see approach. The added value compared to other passive strategies has yet to be proven, particularly in the form of a track record.
Active ETFs seem to combine the best of both worlds. They offer the benefits of regular, passive ETFs alongside those of traditional actively managed investment funds. Morningstar and others expect this type of hybrid investment fund to grow significantly. However, the question remains whether they will outperform the index and whether they are genuinely as active as they claim.
Where a regular ETF delivers a return equal to the tracked index, an active, hybrid ETF aims to outperform the index. A fund manager uses their discretion to adjust the weighting of certain stocks, bonds, economies, or sectors in the ETF›s portfolio.
Active ETFs are set for accelerated growth in both number and assets under management, according to Morningstar. The fund evaluator and investment information provider concluded this in its report published earlier this year, Active ETFs in Europe: Small, Shy, and on the Rise. However, the subtitle immediately offers a caveat about how active this new type of ETF truly is: The universe is growing, but most offerings are less active than you’d expect.
Momentum in Active ETFs
In recent years, the growth of active ETFs has accelerated. Initially, this growth was concentrated in bond strategies. In a low-interest environment, investors saw higher return potential in active management. Over the past two years, active equity ETFs have gained momentum as well. The graph below shows the growth of assets under management in active ETFs, divided across various investment categories. In recent years, investors have clearly invested more in active equity ETFs and active money market ETFs. Growth in active bond ETFs has plateaued.
The growth of active ETFs has accelerated in recent years
Source: Morningstar, data as of 31 March 2024.
Despite their growth, active ETFs still play a modest role in Europe, according to Morningstar. They currently account for around 2 percent of the total assets invested in ETFs. As of 1 March this year, investors in Europe had access to 87 actively managed ETFs, with a total of 33.8 billion euros invested.
In the United States, active ETFs have gained more traction. There, about 6.5 percent of assets invested in ETFs are in the active variant. This growth is also partly due to the tax advantages that ETFs generally enjoy over regular investment funds in the US.
A wait-and-see approach
In the Netherlands, Rabobank and ING are taking a wait-and-see approach. The banks do not yet offer active ETFs to their retail clients. ‘The added value of active ETFs still needs to be proven and made clearer to investors compared to regular passive and smart beta strategies,’ says Mary Pieterse-Bloem, head of the Investment Office at Rabobank.
‘For a client, it’s now clear what a passive or smart beta strategy does. A passive strategy tracks the index at low costs, and smart beta follows the index with some smart adjustments and a low tracking error. As an investor, you know that the future return will be close to that of the index. With an active ETF, you don’t have the certainty that the manager will systematically generate alpha compared to the index. The only advantage of an active ETF over an actively managed fund is its better tradability and liquidity. A thorough analysis of the performance achieved by active ETFs relative to the advantage of better liquidity is therefore advisable.’
Riaan Prinsloo, investment funds analyst at the Investment Office of ING, is also looking for more evidence. ‘The actively managed ETF is an interesting development due to its liquidity and aim for higher returns than the index. But as analysts, we need to closely examine whether these trackers fulfil their promise. A fund manager deviating from the index with their own strategy presents an opportunity, but also a risk. It’s still early days, and there is little return history for active ETFs. I want to see at least a three-year track record and understand how an active ETF performs over a full market cycle.’
Limited active role in Europe
The uncertainty around whether a fund manager can achieve a higher return than the index with an active ETF is also highlighted by Morningstar as a risk. Additionally, the firm points to the higher costs of an active ETF and the reduced diversification compared to a regular ETF. A fund manager and analyst team determining differing positions incurs costs. Deviating from the index can also pose a risk of a less diversified and more concentrated portfolio.
It’s also uncertain how much extra return active management will yield. According to Morningstar, active ETFs in Europe are ‘shy actives’: trackers that are cautiously or conservatively active. With lower active share and alpha, the extra returns—and losses—compared to the benchmark are relatively small. Morningstar concludes that investors should temper their expectations for extra returns from active ETFs.
Thematic investing and multi-asset
Morningstar expects the number of active ETFs to increase. The research notes that more active fund managers are considering packaging and distributing their investment strategies in an ETF format. This is due to the flexibility that an active ETF offers and the popularity of ETFs among investors. For fund houses with active funds, a hybrid ETF is an opportunity to grow and secure a place in the crowded market for regular ETFs. They can promote the active ETF by highlighting the expertise of their own management team.
iShares from BlackRock, known for its index ETFs, also offers active ETFs. Manuela Sperandeo, head of EMEA iShares Product, expects that investors will soon choose a strategy based on their goals and preferences first, and then decide which form suits them best. ‘An index or active ETF, or a regular investment fund. Active ETFs provide more options for differentiation.’
So far, thematic funds make up only a small portion of the assets under management in European active ETFs. Yet thematic investing is well-suited to them, according to Morningstar, given the challenge of constructing a robust thematic index. And as many active thematic funds charge high fees to investors, Morningstar sees potential for lower-cost actively managed ETFs in this area.
Multi-asset is another investment category where Morningstar sees opportunities. Benchmarking a multi-asset fund is already challenging because there is scarcely a universally accepted investable index. Furthermore, active choices are necessary regarding asset allocation. As a result, passive solutions have historically been a small niche in this arena, giving active ETFs a chance to establish a presence.
‘Where the market is inefficient, I see a role for active ETFs,’ says Prinsloo from ING. ‘For example, in thematic investing. But not in an efficient market like US equities.’