Active ETFs Are Outperforming Expectations-Here Is Why
Since the most recent Federal Reserve meeting, the stock markets have been on a rollercoaster ride. The Fed has hinted that the interest rate will be raised in 2023, which is earlier than expected. The news wreaked havoc on the equity markets, which fell last week before resuming their ascent to new highs this week. Investors are unsure what to make of the current landscape and how the anticipated reduction in asset purchases will affect them.
As volatility rises, traders are more likely to engage in active trading, changing their positions in real time to reflect changes in policies and the macroeconomic environment.
Cathie Wood, the founder and CEO of Ark Invest, has become the face of the recent push towards actively managed funds. Exchange-traded fund (ETF) issuers have launched 115 active funds, compared to only 51 passive funds. This is an early indicator of a change in investment strategy.
What Are ETFs?
ETFs are a type of financial asset that tracks the performance of a specific commodity, index, sector, or a specific asset. They can even be used to monitor the effectiveness of investment strategies. ETF shares can be purchased and sold on a stock exchange in the same way that traditional shares are traded.
The primary goal of active ETF managers is to outperform their benchmark, and they have complete control over what they buy and sell to accomplish this. This means they have full autonomy to deviate from the benchmark if they believe it is the best strategy for getting rid of underperforming stocks and replacing them with those with higher potential.
Active versus Passive ETFs
A passive ETF is an asset that seeks to mimic the performance of the stock market or a subset of it. These funds are less expensive, more transparent, and tax efficient when compared to active ETFs.
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Passive funds are less flexible and are highly dependent on the top valued stocks in terms of market capitalization. On the other hand, they are less flexible and rely heavily on the highest-valued stocks in terms of market capitalization.
Active ETFs are traded more frequently on a daily basis and they are required to reveal their holdings as a matter of course. This means they are more actively managed and reflect real time opportunities more advantageously.
Historically, active ETFs have failed to outperform the benchmark net of fees. Over the last decade, passive ETFs have drawn nearly $3 trillion in assets, while active ETFs have attracted only $200 billion.
Wall Street’s growing interest in these funds reflects the ongoing shift. The ETF industry is worth $6.5 trillion. Active funds account for a small portion of the total pie, but their growth rate has increased from 2.7% a year ago to 3.4% now. New regulations, as well as the growing popularity of ETFs among investors, have prompted this shift in strategy.
Why Are Active ETFs Becoming More Popular?
With the rise of active funds, investors are forced to consider why this strategy is being adopted at this moment. Various factors behind this movement are explained below.
ETFs have a number of advantages over other securities, making them the preferred medium for many investors. ETFs are popular due to their unique tax advantages, as well as their ease of trading and increased liquidity.
Active ETFs supplement these advantages by allowing companies to respond more quickly to changes in market conditions. However, investors should keep in mind that the fee for an active ETF is 0.72% compared to 0.49% for a passive ETF.
Stock Market Performance
Stock markets around the world have been breaking records, and investors are pouring money into the markets like never before, increasing the likelihood of active ETFs outperforming their benchmarks. This is because investors are upbeat as economies around the world recover from the Coronavirus pandemic.
Furthermore, active funds held a higher proportion of winning stocks in the Russell 1000 index. In April, 46% of ETFs outperformed the benchmark, while in May, 54% surpassed the benchmark, according to Bloomberg.
The reason that active ETFs have been delivering so exceptionally recently is due to their ability to capitalize on the shift away from Big Tech. These funds have switched to other valuable stocks, such as financial firms that, according to analysts, are trading at a discount to their earnings or book value.
Boom in Retail Investments
Active ETFs are also gaining traction as investors seek to capitalize on the retail investment boom. As a result of statewide lockdowns and higher savings during the pandemic, the number of retail investors in the United States has risen significantly. Individuals have entered the stock market to augment income lost due to the pandemic and to compensate for low interest rates on savings accounts. Similarly, increased accessibility to digital devices and low-cost applications has boosted non-professional stock market investments.
The Chicago Board Options Exchange Volatility Index (VIX) is a popular measure of what investors expect volatility to be in the short term based on options traded on the S&P 500. Last week, the VIX index increased by 16%, reaching its highest level since March. This reading demonstrates the sharp rise in investor uncertainty. The Fed has been forced to reconsider its monetary policy and taper bond purchases to achieve a faster economic recovery. In the coming months, this situation will add to investors’ concerns.
Growth of Thematic Funds
Since the beginning of 2021, the momentum toward thematic funds has also risen, with a record 22 thematic funds being launched. Companies are working to diversify those thematic products in which they invest based on compelling narratives such as entertainment and sports. BlackRock’s U.S. Carbon Transition Readiness ETF, worth $1.4 billion, is an example of a thematic fund that set the industry record for the largest launch in April.
Investors and companies alike have yet to determine whether they can compete with Cathie Wood’s spectacular returns on active funds or if they will continue with the historically poor performance of fee-dominated active funds.
Cathie Wood has been at the forefront of the current revolution where investors are shifting towards active funds. She oversees five of the market’s most popular active funds. Her active trading strategy, combined with her stock picking prowess, has enabled her active funds to post triple-digit returns in 2020 and reach $60 billion in assets.
Wood’s active trading strategy enabled her to profit from Tesla’s stock price drop. ARK Innovation ETF (ARKK) pumped more money into Tesla in September after the company missed out on being included in the S&P 500 and following news about General Motors and Nikola. Since the move, Tesla’s stock price has increased by nearly 140%, while ARKK’s stock price has increased by nearly 83%.
The Bottom Line
Moving forward, investors are very likely to prefer active funds over passive funds due to the ever-changing stock market dynamics caused by reports of rising inflation. This may force the Fed to consider tapering off its stimulus sooner than expected, resulting in greater uncertainty about what the future holds for investors. Thematic ETFs are likely to be the most favorable asset class and it is highly possible that we may see more of them coming to the market in the near future.