In the first half of 2021, investors accelerated their move into passive investments and lower-fee products. There’s also a small countermovement: some stock pickers have launched exchange-traded funds (ETFs). Will these active managers be able to make any money in ETF land? While fee compression continues to affect every asset major class and strategy, 2021’s year-to-date fee pressure has been strongest in actively managed equity ETFs.
Ongoing Shift Away from Mutual Funds
In 2015, according to data from the Investment Company Institute (ICI) and FactSet active management in the overall U.S. public fund market was 71% active, 29% passive, and mutual funds commanded 86% of fund assets. The split was lopsided. Mutual funds were 83% active, 17% passive; ETFs were 99% passive and only 1% active.
By the end of 2020, mutual funds had lost some popularity and passives had grown substantially to 40% of the U.S. fund market. Mutual funds, now 78% of all fund assets, stood at 75% active and 25% passive. ETFs, with 22% market share, inched in the opposite direction as passive exposure dropped to 97% and active rose to 3%.
A tiny but growing minority of U.S. investors are showing interest in actively managed ETFs to the tune of $83 billion in of net inflows through June 30. That’s 16.7% of net U.S. ETF flows to a segment that comprises just 3% of the asset base. In contrast, vanilla and smart beta funds captured 58% and 18% of the flows despite comprising 70% and 20% of the starting asset base.
It’s no wonder that ETF flows have been accelerating. Compared to mutual funds, ETFs offer lower operating costs and potentially higher tax efficiency. Asset managers are following their clients with more old-line mutual fund firms launching ETFs. Some have been converting mutual fund assets directly to ETFs, while others have started from scratch.
Fee Compression Continues
With a new fund type come new challenges for active managers. Not only must they compete on performance, but they must do so in a fiercely contested landscape with a laser focus on fees. All must decide on how to price their new ETFs—a daunting task in a margin-demolishing industry. ETF fee compression affects every asset class and investment strategy, but the magnitude of the impact varies considerably. Expense ratios in some segments have long since collapsed to near zero, while others have further to go. Some, like smart beta/strategic fixed income, are falling faster while others, like strategic equity, more slowly. None has collapsed as dramatically as actively managed equity.
At the end of June, active equity ETFs that gained market share during the first half of 2021 had an asset-weighted expense ratio of 0.53%, while those that lost market share cost 0.72%. The chart below shows how extreme this move is.
Competition Drives Fee Compression
ETF investors are spoiled for choice with 2,563 funds trading on U.S. exchanges as of June 30. Of these, 1666 funds offer exposure to equity markets. Surprisingly, 244 or 15% of the equity ETFs are actively managed. Active ETF managers now compete not only with their passive counterparts, but with their active peers. Performance matters, but so do costs, which detract from performance. Investors have taken notice. In market segments where multiple active ETFs compete, funds with lower fees are gaining market share while those with higher fees are losing out. The chart below shows the fee differential among active ETFs in segments with at least $1 billion under active management.
In most of the broad market segments and U.S. small- and mid-caps, investors are making a dramatic show of preference for cheaper funds. Of the eight ETFs offering active exposure to developed ex-U.S. market equities, 41% of all active flows went to Dimensional International Core Equity Market ETF, which costs just 0.18%/year, and another 44% went to Avantis International Equity ETF with a price tag of 0.23%. In contrast, the four funds that cost between 0.59% and 0.83% per year jointly garnered just 8% of the flows to actives in this segment.
Similarly, in the U.S. total market and large-cap segments, 104 actively managed ETFs compete. The cheapest quartile, which cost less than 0.40%, garnered $3.5 billion in the first half of 2021, while the most expensive quartile attracted less than half a billion. The chart below shows the breakdown of the flow by expense ratio groupings with flows exclusive of AUM converted from mutual funds.
This chart would be far more cheap-fund-skewed if it included the $17.7 billion in Dimensional’s U.S. Equity and U.S. Core Equity mutual funds converted into ETFs costing 0.11% and 0.19%, respectively.
Fee Compression Spans All Active Investment Strategies
There’s plenty of room for further fee compression among actively managed ETFs. The asset-weighted average expense ratio for actives ended June at 0.56%, more than twice that of smart beta funds and four times that of vanilla funds down from 0.72% at the end of 2020. Mutual fund conversions played a large role in accelerating the drop, but big as these new ETFs are, they comprise just 11% of active ETF AUM.
Active ETF fee compression is gathering steam. The chart below compares the rate of fee compression across investment strategies.
As investors continue to embrace ETFs, the fund landscape shifts. Mutual funds are losing ground to ETFs and active management is giving way to passive while costs sink ever lower. The countermovement of active management into the ETF space has bucked the passive tide but has not managed to escape the fee wars. So far in 2021, we have seen active ETFs take the fee compression spotlight. Competition shows no sign of letting up.
The information contained in this article is not investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.