Key Takeaways
- Active ETFs trade intraday. They have some tax benefits, and you’re going to get the same thing you’d get in a mutual fund with a manager picking stocks trying to beat an index instead of replicate one.
- Active ETFs are portable, cheaper than mutual funds, and tend to be priced pretty close to the institutional shares. They also tend to have really low investment minimums.
- Active ETFs being cheaper lowers their hurdle rate, and lower fees are always going to tip the odds in investors’ favor.
- ETFs can’t close to new investors like a mutual fund can, which creates a challenge for more liquidity-constrained strategies like small caps.
- Even though active ETFs are going to be cheaper, it’s still really paramount on investors and advisors to do their homework and really pick managers they think have an endurable edge that can lead to better results, especially given the lower fee structure.
Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. While most stock ETF assets are held in passively managed products, asset managers are launching actively managed ETFs, and some of these active ETFs are run by well-known and successful stock fund managers.
So, what are the pros and cons of active equity ETFs? And what questions should you be asking before you buy one? Here with me to unpack it all is Jason Kephart. Jason is a senior principal with Morningstar’s multi-asset team.
Hey, Jason. Good to see you.
Jason Kephart: Thanks for having me, Susan.
What Is an Active ETF?
Dziubinski: All right, let’s start with the basics. What is an active ETF?
Kephart: Most people are probably familiar with passive ETFs. What they do is they track an index like the S&P 500 or the Russell 2000. And what really separates them from mutual funds is they trade intraday and they have some tax benefits. And what we’re seeing is more asset managers are launching active versions of ETFs that basically are the same thing you’d get in a mutual fund. You’re going to get a manager picking stocks trying to beat an index instead of replicate one. And that’s what we’re seeing that’s kind of the rise of active ETFs.
Why Asset Managers Are Launching Active Equity ETFs
Dziubinski: So, now, why are asset managers launching active stock ETFs?
Kephart: I think, for the most part, it’s really being driven by taxes first. Mutual funds are not very tax-efficient, particularly for equity funds, and ETFs are a bit more tax-efficient, which I think we’ll get into a little later. But also, active ETFs have a couple of other advantages. They’re portable. It doesn’t matter what platform you’re going to be on; you can get access to them. Also, they tend to be much cheaper than mutual funds. They tend to be priced pretty close to the institutional shares—which a lot of individuals might not have access to because they can’t reach the high minimums—but they also tend to have really low investment minimums, too. So, for younger people who don’t have $2,500 to buy an A share of an active equity mutual fund, they can get an active equity ETF for a couple hundred bucks.
Are Stock-Focused Active ETFs Clones of Mutual Fund Strategies?
Dziubinski: Are most of the active ETFs that are coming to market today—that focus on stocks—are they simply clones of mutual fund strategies, or do we have more unique strategies coming to market in this ETF wrapper?
Kephart: When it comes to your classic stock-picking active equity strategies, what we’re seeing is more clones that are not quite clones. They’re going to have something like 90% overlap, so very similar. They’re going to follow the same investment process, and they are going to look a lot like their mutual fund siblings, but they’re not going to be clones per se. So, maybe small performance differences.
We have seen a couple of notable unique fund launches. One I would point to is David Giroux from T. Rowe Price. He runs T. Rowe Price Capital Appreciation, which has an equity sleeve that’s done really well and previously was not accessible outside of his multi-asset fund, but he’s launched an ETF, the ticker’s TCAF, that is just pure stock-picking. So, that is what I would think of as a really notable new product.
Advantages of Active Equity ETFs
Dziubinski: Got it. Morningstar research has shown over time that active funds tend to lag passive funds in most stock categories. So, why would an investor want to bother with an active ETF focused on stocks?
Kephart: Yeah, I think one of the biggest hurdles active managers have to beating indexes is the fees. And with active ETFs being cheaper, that lowers that hurdle rate. Now, it’s not going to be a magic formula that all of a sudden you launch an active ETF and all of a sudden you’re going to be beating the S&P 500, but it does make it easier. So, if you are picking really good managers that you think have an edge over the long term, lower fees are always going to tip the odds in investors’ favor, and active ETFs definitely have that going for them.
How Are Active Equity ETFs More Tax-Efficient Than Mutual Funds?
Dziubinski: OK, so Jason, ETFs have traditionally been more tax-efficient than mutual funds, and that has to do with the structure of an ETF itself. So, theoretically, walk us through an example of how an active equity ETF is more tax-efficient than an active mutual fund.
Kephart: Let’s start with the mutual fund. One of the flaws of mutual funds in a taxable account is every calendar year they’re forced to distribute any capital gains to shareholders, which can be a really annoying and maybe painful experience if you weren’t expecting to get a tax bill. But with active ETFs, they’re not forced to do the same thing, so you only are really going to pay capital gains when you choose to sell. What other investors in the fund do won’t really affect your capital gains situation. So, that’s really what really helps make active ETFs more efficient.
Cons of Active Equity ETFs Versus Active Equity Mutual Funds
Dziubinski: All right, Jason, it sounds like active equity ETFs actually have a lot going for them. Are there any cons over an active equity ETF versus an active equity mutual fund?
Kephart: Yeah, there’s one big con, I would say, and that is that ETFs can’t close to new investors like a mutual fund can. So, think about a small-cap strategy. Those tend to be capacity-constrained. If a fund gets too big, the manager might not be able to execute their strategy in small stocks the way they had when the fund was smaller. And an ETF can’t do that, so that does create a challenge, I think, for more liquidity-constrained strategies like small caps. Large caps—probably not as big a concern—but I think small-cap active ETFs you’d want to keep a close eye on, particularly if there’s a lot of stock-picking going on.
Ask Your Advisor These Questions Before Investing in Active Equity ETFs
Dziubinski: Let’s wrap up with some key questions that investors should be asking their advisors before they would actually go ahead and invest in an active equity ETF.
Kephart: I think the first thing to keep in mind is that whatever the wrapper is, stock-picking is very difficult. It’s very hard to beat indexes over the long term, especially given how cheap passive ETFs are. You get the S&P 500 for a couple of basis points. So, even though active ETFs are going to be cheaper, it’s still really paramount on investors and advisors to do their homework and really pick managers they think do have an endurable edge that can lead to better results, especially given the lower fee structure.
Dziubinski: Jason, thank you so much for your time today. We appreciate it.
Kephart: Thanks for having me.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
Watch 3 Great Balanced Funds for 2025 for more from Jason Kephart.