‘Active ETFs’: Inside the booming (and potentially profitable) new investing trend

With the markets soaring to new highs, investors infused a net $566 billion of assets into ETFs by Aug. 23, according to independent equity research company CFRA. Since January, fund managers launched 235 new ETFs and 135 new open-end mutual funds into the market, according to Morningstar Direct data.

Just this week, Capital Group, one of the country’s largest asset managers, filed registration documents for its first-ever set of exchange-traded funds, a “key milestone for the ETF industry,” according to Todd Rosenbluth, director of mutual and exchange-traded fund research at CFRA. Capital Group was one of the last major asset managers still holding out on the exchange-traded format, which was developed back in the 1990s. ETFs, which trade intraday on exchanges, were a novel investment vehicle intended to make investing in an index or specific market sector more accessible, affordable, and liquid to investors. In general, their fees are lower—equity mutual funds, on average, charged about 0.50% in 2020, while index equity ETFs averaged 0.18%, according to the Investment Company Institute. ETFs also don’t have the investment minimums often paired with mutual funds.

But one of the most interesting corners of this market for investors is so-called active ETFs, where portfolio managers are still deciding what to include or exclude in order to outperform a traditional index, but are using the tax-efficient exchange-traded structure to add liquidity and keep costs low. That’s a big change as nearly all of the ETFs on the market today have passive strategies that closely track an index, whether it be made up of stocks, bonds, commodities, or some other asset class. But in the past two years, more and more portfolio managers have begun introducing their active strategies into the ETF wrapper, and they’re starting to really pick up traction from investors. Here’s an example: Fidelity, earlier this year, replicated its Fidelity Women’s Leadership Fund (FWOMX), a mutual fund, and launched the Fidelity Women’s Leadership ETF (FDWM), an active ETF with the same strategy. This year we’ve also seen funds converted into ETFs, as well as brand-new active strategies emerging in the exchange-traded format.

Investors are loving it. Approximately 12% of net flows into ETFs this year have circulated in those with active strategies, according to CFRA. Considering that only a tiny slice of the total assets ETF market—4% of the total $6.7 trillion ETF market—are held in active funds, this is a dynamic change. 

Here’s why this is happening: For starters, it’s a lot easier to launch an ETF than it was just two years ago. In September 2019, the SEC approved rule 6c-11, known as the “ETF rule,” which eliminated requirements for asset managers to file for exemptive relief to launch an open-ended ETF. It became cheaper, faster and generally easier for asset managers to launch an ETF.

“It took barriers to entry that were already frankly pretty low, and had come down over the years, and all but eliminated them,” says Ben Johnson, director of global ETF research at Morningstar, which rates mutual funds and ETFs.

Another reason for the influx of new funds: ETF managers can now opt to disclose their holdings on a quarterly, rather than a daily basis. The SEC approved the first exchange-traded fund that wouldn’t disclose daily holdings—called a “non-transparent ETF”—in June 2019. Until then, that disclosure requirement had been a major drawback for portfolio managers who were adamant on keeping their holdings under wraps, whether it be to keep their research proprietary, or to try to prevent competitors or other investors from trading ahead of them. Mutual funds had always offered this privacy—and now ETFs could too. 

Both of these regulatory changes, combined with ever-growing investor demand, have led to a flurry of asset managers launching new ETFs, and they’re telling a bigger story about innovation and how asset managers are making money when fee compression is squashing their margins. Here’s a look at some of the newer entrants from this year:

Going green + “S” and “G”

ESG continues to be one of the fastest-growing areas of the fund market. In the first six months of 2021, assets in sustainable funds grew by 12% globally to $2.24 trillion, according to Morningstar. There have been a host of new ESG fund launches this year—with 36 in the first half alone, according to Morningstar. Here are a few worth noting.

The BlackRock US Carbon Transition Readiness ETF (LCTU), which launched in April and has an expense ratio of 0.30%, had the biggest first-day launch in ETF history, drawing in $1.3 billion in assets within its first day of trading, according to Bloomberg. The fund invests in large-cap and midcap companies best positioned for a low-carbon economy. It was up 10.5% from inception Aug. 24, compared to the S&P 500, which was up 10.1%.

Engine No. 1, an activist investment manager, made a name for itself earlier this year when it took the rare step of winning seats on Exxon Mobil’s board in an effort to reduce the company’s carbon footprint. It shortly after launched the Engine No. 1 Transform 500 ETF (VOTE), which focuses on utilizing investor voting to hold major companies accountable to climate change. It has collected $174.4 million in assets since its launch at the end of June and has a net expense ratio of 0.05%. It was up 6.3% on Aug. 24, versus the S&P 500, which was up 5.8%.

The Gabelli Love Our Planet & People ETF (LOPP), which went live in January, is waiving the first year of fees for its first $100 million in assets, after which it will charge total annual fees of 0.90%. It’s an active, non-transparent ETF that invests in publicly traded, sustainably-focused companies, and it was up 16% from launch Aug. 24, compared to the S&P 500, which was up 18.9%.

I’ll point out that funds focused on social funds, while not as popular, have been gaining steam as well. One of the new entrants this year is the LGBTQ + ESG100 ETF (LGBT), which is a thematic index fund that launched in mid-May that seeks exposure to large-cap companies committed to LGBTQ diversity and inclusion. It is currently trading up 8.9% from inception, compared to the S&P 500 at 8.7%, and has an expense ratio of 0.75%.

New and active

With the newfound popularity of active ETFs, even some of the most well-known asset managers or funds are rolling out exchange-traded products.

The Fidelity Magellan Fund (FMAGX) is one of the most storied investment funds of all time—the top performing fund in the world between 1977 to 1990. In February, Fidelity released it as an exchange-traded product, the Fidelity Magellan ETF (FMAG). It now has a cheaper price tag, at 0.59%, compared to the mutual fund’s net expense ratio of 0.79%. It was up 17.6% on Aug. 24, versus the S&P 500, which was up 15.9%.

Cathie Wood was one of the first active portfolio managers to gain steam embracing the ETF and readily disclose holdings on a daily basis. ARK Invest launched its latest fund, the ARK Space Exploration & Innovation ETF (ARKX) in March, which has already accumulated $626.8 million in assets. It charges 0.75% and was up 0.59% from inception on Aug. 24, versus the S&P 500, where the price was up 13.3%.

While not a fund launch per se, it’s worth noting that Dimensional Fund Advisors converted four of its mutual funds into ETFs earlier this year, which makes DFA’s strategies available directly to retail investors, rather than just financial advisers. DFA, which launched its first ETFs in 2020, converted four tax-advantaged mutual funds, which now trade under the tickers DFUS, DFAC, DFAS, and DFAT.

COVID, SPACs, and millennials 

Pick a topic, and there’s probably already an ETF for it (that is, unless you pick Bitcoin). Which brings us to some of the most unusual active ETFs that have hit the market this year.

A handful of funds emerged hoping to capitalize on the U.S. economy reopening, such as the AdvisorShares Restaurant ETF (EATZ), which is down 4.3% since its launch (the S&P 500 is up 7.5% in comparison), or the SonicShares Airlines, Hotels, Cruise Lines ETF (TRYP), which is down 5.7% since inception (compared to the S&P 500 at 9.1%).

When it comes to what’s trending, you can invest in the Netflix and Hulu craze with Roundhill Streaming Services & Technology ETF (SUBZ). Investors can make sure they’re not missing out with the FOMO ETF (FOMO), which seeks to invest in whatever is currently trending on the market. The VanEck Vectors Social Sentiment ETF (BUZZ) aggregates social media, news articles, blogs, and other “alternative data sets” to pick stocks with bullish investor perception.

There are also a handful of new funds focused on accessing the SPAC market, including Tuttle Capital Management’s De-SPAC ETF (DSPC), which invests in companies that have gone public via SPAC, or you can short them with its counterpart, the Short De-SPAC ETF (SOGU). 

Risky business

It’s worth mentioning that it’s pretty hard to guess how any of these funds will be performing a month, a year, or five years from now (a fool’s game, if you ask me). Funds that don’t perform well, or fail to pick up any traction from the onslaught, run the risk of being closed, which isn’t great for its investors. I’ll highlight that investing in a new fund with zero track record—and particularly if its portfolio managers have no track record—can be risky business. Any investment decision should always involve thoughtful research as well as some study of where, and if, a new investment fits in with a preexisting and hopefully diversified portfolio. 

Either way, it’s always worth keeping an eye out for what’s new on the market, even if it’s just window-shopping. There just may be a gem.

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JARGON, EXPLAINED 

“ANT”—“Active non-transparent” funds only have to disclose their holdings to investors on a quarterly basis, rather than daily. However, asset managers can get creative with what that looks like, as there are several ETF structures to choose from. Some asset managers don’t disclose their portfolios at all, while others disclose a portion, generate a proxy portfolio, or simply keep their weightings quiet. ETFs that disclose portions of their portfolio are sometimes referred to as “semi-transparent” funds, perhaps because it sounds a little less daunting than "non-transparent."

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SoFi’s robo adviser, SoFi Wealth, was sued by the SEC for allegedly not disclosing conflicts of interest within its business model and for favoring its parent company's proprietary ETFs. The company agreed to pay a penalty of $300,000 but didn’t admit or deny the SEC’s charges.

As a reminder: Broker-dealers and investment advisers are required to disclose any of their conflicts of interest to investors in what’s called a customer relationship summary document, known as the “Form CRS.” Under SEC rules, companies have to post this document on their websites. You can also find them online: Broker-dealers (like Fidelity or Robinhood) have to publish them here, and investment advisers (like Betterment or Merrill Edge Guided Investing) must disclose them here.

We’re just getting this column off the ground, so send me your thoughts and feedback below. Thanks for reading. 

Jessica Mathews
Twitter: @jessicakmathews
Email: jessica.mathews@fortune.com

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