Investment Strategy

Why Investors are Jumping into Managed ETFs

Warren Buffett has been a long-term advocate of passive index funds (ETFs) and says that you should be too. While his wealth has come from a modicum of highly successful dividend stocks, he believes that the average investor is better suited for an index fund.

After all, he states, most professional money managers can’t beat the market, so how is the novice going to do it? Like dividend growth, time and compounding can be on your side if you are invested in index funds for the long term. The most notable bellwether fund would be the S&P 500, as encompassed by the SPY or VOO. So why not heed Buffett’s advice and put your portfolio on autopilot?

Let’s size up these managed ETFs and take a look at the pros and cons. The obvious pro is an attempt by active management to beat a passive index like the S&P 500. As well, the obvious con is that it costs more to actively manage. A more esoteric reason for managed funds is the current volatile market environment, with the subliminal message being that you can’t beat the current market by being passive.

Money flowing into managed ETFs tells the story.

According to Bloomberg Intelligence, 30% of new capital flowing into ETFs this year are into managed funds, following up another big year previously in 2022, whereby 14% of total funds went into managed ETFs. In addition to the notion of helping manage volatility, actively managed ETFs give investors more flexibility to easily trade specific strategies.

Just like passive index funds, the larger players are entering the market, giving investors not only additional managed options but brand names that they are familiar with. JPMorgan is leading the way currently with 12-month capital inflows totaling roughly $7.1 billion. The fund, symbol JEPI, has used an options strategy to produce income as well as total returns. It launched in 2020 and has exploded in popularity, roughly quadrupling its assets under management from $5.8 billion at the start of 2022 to $24.6 billion today.

The following list will give you some guidance as to the largest managed ETFs this year.

Let’s take a look at some of the basics behind these managed funds and try to determine if they make sense to allocate capital to.

  • An actively managed ETF has a manager or team that selects holdings based on their research in an attempt to outperform its benchmark.
  • Actively managed ETFs may have lower fees and expense ratios than actively managed mutual funds, but they typically have higher costs than index funds or passively managed ETFs.
  • The majority of actively managed ETFs, like actively managed mutual funds, do not often outperform index funds or passively managed ETFs.
  • There are fewer actively managed ETFs than passively managed ETFs for you to choose to invest in.

Perhaps the best known example of a managed ETF would be the ARK Innovation ETF (ARKK) managed by a team led by Cathie Wood. The fund prospectus states its objective is to seek long-term growth of capital by investing at least 65% of its assets in shares of companies that it feels are relevant to its theme of “disruptive innovation.” The ARK ETF isn’t for the faint of heart, however, and certainly hasn’t taken the volatility out of investing.

In 2020, a year in which the fund’s predominantly high-tech holdings performed well, the ARK fund returned more than 152%, while the S&P 500 returned just 16%. However, last year was brutal, finding the fund down 67% with major capital outflows.

If you can select the right managed ETF, there are several quantifiable benefits.

Lower Fees: In comparison to passively managed funds, you’re going to pay more for the active management, but compared to the past industry standard of mutual funds, you’ll pay less. U.S. News reports the average annual fee for an active stock mutual fund is 1.39%, while it is 0.82% for an active stock ETF. Other surveys show active bond ETFs have an average fee of 0.49%.

Greater Liquidity: Mutual fund investors can only buy or sell their shares once every day, at the end of the trading when the fund NAV is struck. This may be fine for some, but those who want to trade intraday will matriculate to ETFs. With Active ETFs, because they provide intraday indicative values which approximate the fund’s NAV, investors are able to trade intraday just as they can with any other ETF.

Greater Tax Efficiency: ETFs, whether active or passive, are, in general, more tax-efficient structures than mutual funds. The main difference is that investors in active ETFs don’t pay taxes until they sell their own shares. In mutual funds, however, investors may incur taxes when the portfolio manager has to sell securities to fund other investors’ redemptions. This is how you can actually pay taxes with the fund losing money for a given year.

At the end of the day, I believe the jury is still out on actively managed funds. If you buy into the theory that the current market environment dictates management, the pros may outweigh the cons.  An actively managed ETF may outperform its benchmark significantly, only to drastically underperform in a down market due to higher risk.

If you are a long-term Buffett disciple, it may make sense just to be the market in the form of a passive index fund like the SPY.

Investment Strategy