Can active ETFs outperform their way into more portfolios?

Active asset managers are betting that financial advisors and investors will move some of the trillions of dollars in cash vehicles into ETFs that cost more but may outperform their peers.

Money-market funds fueled by rising interest rates and yields topped $6 trillion in assets for the first time at the end of last month — just as passive mutual funds and ETFs reached a long-anticipated milestone by eclipsing the holdings in active strategies. Newer products that are gaining more notice could still win over advisors and investors who are likely to cut the cash allocations in their portfolio once the Fed proceeds as expected by slashing interest rates later this year, according to active managers.

"The reason we're investing in women CEOs is because we think they will outperform. To the extent that an active strategy can consistently outperform other alternatives, it will continue to garner assets," Patricia Lizarraga, the managing partner of Hypatia Women CEO ETF (ticker: WCEO) issuer Hypatia Capital, said in an interview. "The active ETF market will continue to grow as people will continue to want to have a view as to what's going to outperform in the market."

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The fund managed by Lizarraga's firm represents a thematic impact investment, which is part of the universe of active products. The WCEO fund usually holds around 130 stocks in firms with female CEOs, and it fits into the small-market capitalization allocation of a portfolio because its issuer identified every publicly traded firm led by women then isolated for its thesis by correcting for size and industry concentrations, she noted. For 2023 after the fund's inception last January, the ETF yielded 11.32% in terms of its market value. It charges an expense ratio of 0.85% — an amount that's much higher than small-cap index funds but comparable to other impact vehicles.

Actively managed bond ETFs from Capital Group, the owner of American Funds, and other more conventional fixed-income strategies are vying for investors as the Fed's anticipated cuts to interest rates drive renewed investor appeal. Capital Group has launched a half dozen actively managed bond ETFs since February 2022, and the firms active ETFs reached more than $21 billion in client assets across equities and fixed income. 

"Until recently you couldn't package active management in an ETF structure," Capital Group Global Head of Product Strategy and Development Holly Framsted said in an interview earlier this month. "We think that this structure can be incredibly beneficial, and you no longer have to sacrifice active management."

The group includes products with expense ratios between 0.25% and 0.39% aimed at short-duration, core holdings, municipal bonds and income-generating allocations. The average cost ratio for a bond ETF tumbled by 14 basis points to 0.11% between 2009 and 2022, according to the Investment Company Institute's latest annual fund report. The four Capital Group funds that launched prior to last year each rose in market value by more than their respective benchmarks for 2023.

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Just 12% of fixed-income ETF assets are in active strategies, while 78% of holdings in bond mutual funds have flowed to active vehicles, according to Morningstar data from the end of 2023 cited by Framsted. In a survey between late September and early October held by Capital Group with a sampling of 400 advisors from across the industry, the company found that the group allocated less than 4% of their assets under management to active bond ETFs.

"Active fixed-income ETFs are, we believe, going to be the asset allocation story of the year," Framsted said, noting the investor cash that's currently in money markets. The active bond ETFs will be "a really important part of client conversations this year and in years to come," she added.

Active bond managers are facing a steep uphill climb, though. Between the start of 2022 and the end of November 2023, active fixed-income mutual funds and ETFs sustained outflows of $547 billion while their passive counterparts drew an in-flow of $410 billion, Bloomberg News reported last year. Still, many active managers view their technology and expertise as giving them the edge over the passive products. 

"The case for passive in my mind is not a very strong one in fixed income," Neuberger Berman Group CEO George Walker told Bloomberg. "Passive has outperformed in certain parts of the U.S. large-cap equity markets, but I think over time people will become more discerning on the best use."

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To get in front of more advisors and investors, smaller funds must overcome the chicken-or-egg problem of the sizable assets under management required to gain access to a lot of intermediary platforms used by large wealth management firms. WCEO has between $3 million and $4 million in assets, and it's available through large discount brokerages and other self-directed platforms, Lizarraga noted. She aims for more investors to find the fund and invest based on the fund's thesis and criteria that's been under development since 2018.

"It's harder for women to become CEOs, so the ones that do are by definition extraordinary," Lizarraga said. "If the CEOs that get to the top jump over those additional barriers, they should be better."