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The new kid’s back in town and he’s a bully. Remember active mutual funds? Get ready because here come active ETFs. In 2019, there were only about 350 of those guys, but now that number has ballooned to almost 1,500. Remarkably, active ETFs gobbled up over 20% of the net asset flow into stock ETFs in the first half of this year.
According to one active ETF advocate, actively management has become more popular as heavyweight asset managers have entered the fray. Fidelity and T. Rowe Price have already thrown their hat in the ring. Even our stalwart friend Vanguard has just launched two active bond ETFs, although as yet the fund group has not offered any purely active stock counterparts.
Now here comes the propaganda. How about, “The Investor’s Guide to the Rise in Active ETFs?” Check this one out: “Why Assets Are Flowing into Active ETFs.” What’s the hurry? It’s obvious. The big boys’ enriching high-fee mutual fund is fast becoming extinct and they need to replace it with a slam-dunk alternative. Hence, the advent of the active ETF, with a cost below the mutual fund fee and only moderately higher than that of the time-tested index fund.
What to worry? See, Vanguard already has five stock ETFs classified on its website as active. Launched in 2018, they have languished in obscurity, bypassed by the index fund faithful. I set out to show how the performance of Vanguard’s active stock ETFs—Minimum Volatility, Momentum Factor, Multifactor, Quality Factor and Value Factor—was trounced by that of index ETFs categorized as comparable by Morningstar, the premier fund advisory service.
Folks, that’s not what happened. Quite the reverse, and I’m as dumbfounded as you’re going to be when you peruse the table below.
5-Year Average
Active ETF Annual Total Return Risk TO Category
Minimum Volatility 8% 65 26% MC Blend Momentum 14% 83 73% MC Growth Multifactor 12% 82 37% MC Blend Quality 13% 77 55% MC Blend Value 12% 87 24% MC Value
Passive Index ETF
Midcap Growth 10% 79 14%
Midcap Blend 9% 76 13%
Midcap Value 9% 76 22%
Notes:
Total return taken from Vanguard.
All five active funds are classified by Morningstar as midcap blend, growth or value.
Risk refers to Morningstar’s Portfolio Risk Score.
The price/earnings ratio from Morningstar averaged 16 for the active ETFs versus 22 for the index ETFs.
Turnover (TO) was taken from Morningstar.
Takeaway
Believe me, I’m as befuddled as you are. The finding that the active ETFs generally performed better than their passive counterparts is, of course, highly counterintuitive. That they did so in the absence of greater risk makes the result even more perplexing. Last, I searched for whether the stark outperformance of Vanguard Momentum might be due to a large technology overweight but, currently at least, this proved not to be the case.
Some caveats. Although Vanguard’s “active” ETFs did display higher turnover than their comparable index ETFs, they are not pure active prototypes– they are factor funds. They do not depend on a portfolio manager’s judgment and so are probably better denoted as “smart” ETFs. Besides, the active ETFs’ advantage is only marginally actionable since their volume is very low and so their bid/ask spreads prohibitively large.
Even then, the study’s outcome is curious, all the more so since the active ETFs’ gains were made in the face of slightly higher average cost (.13 vs. .06). Of course, Vanguard could yet choose to enter the race towards stock ETFs. But if history is any guide, we can anticipate the hoopla surrounding their arrival and the proliferation of active offerings on the ETF landscape to be fleeting.
Interesting comparison, though, several of Vanguard’s active mutual funds have been exceptional. My employer dropped the Vanguard Capital Opportunity fund, but I was able to switch this15% of my allocation to the Primecap fund. It has gained an average of 15% over 5 years and 13.75% per year since 1984! Their total market fund, though, is the core holding. Vanguard is recommending a tilt towards international index funds for the next few years—not sure about that? Any thoughts?
Hi BMORE,
You’re so correct, Primecap has been a category outperformer over the last 5, 10 and 15 year periods, a truly unusual feat and a difficult one for efficient market observers to explain away. As far as international stocks go, anyone who knows my own trading history would warn you about some of my less than stellar calls. But, yes, Vanguard and a lot of other advisory groups see foreign markets (and small cap stocks) as presently undervalued.
Steve, thanks for the post. I’m not sure I’d consider the five funds you cite as active. Rather, I’d consider them factor or “smart” beta ETFs. But obviously Vanguard disagrees if it’s labeling the funds as active. Or is that just marketing spin by Vanguard? Somewhere, poor old Jack may have a scowl on his face.
Jonathan, I know exactly what you mean. Factor funds are in their own world.They’re not static like an index fund and the periodic factor adjustments generate a fair amount of turnover, but they’re not subject to the whims of a portfolio manager. It seems like their overall middling performance has dampened the early enthusiasm of a few years ago.
I hold VFMF (Multifactor) as my “factor tilt.” Almost all the rest of my stock holdings are index funds.
Randy, I’m with you. I’vc always liked the multifactor version best because it just makes more sense. You get exposure to factors identified as performance-enhancing and the diversification as well.