While mutual funds suffer losses, active ETFs continue to flourish

Despite a 20% drop in active mutual fund holdings, strong inflows help ETF assets climb

While mutual funds suffer losses, active ETFs continue to flourish

As mutual funds get crushed by a devastating combination of investment losses and unprecedented outflows, exchange traded funds are proving to be a rare glimmer of hope for active fund managers under siege.

According to data from Morningstar, investors worldwide withdrew a net US$640 billion from actively managed mutual funds in the first half of the year, a sharp decline from inflows of US$943 billion in 2021.

These withdrawals, coupled with market declines, caused total assets to plummet by 19.6% to US$23.9 trillion, reported the Financial Times.

Morningstar further reports that the far more modest but still-developing active ETF market was able to draw a net US$51.8 billion during the same time period, which is in line with its projected growth rate through 2021. Assets have increased by 1.2% to US$385 billion, even after accounting for market losses.

The demand for active ETFs is holding up even better than that for passive funds, with worldwide flows into passive mutual funds and ETFs in H1 at US$431 billion, less than a third of the total for 2021.

“There has been a general trend away from mutual funds towards equity ETFs more broadly, and active ETFs have very much participated in that move,” Chris Gooch, head of ETF and index sales, Emea at Citi, told the Times.

Elisabeth Kashner, director of global fund analytics at data provider FactSet, said that the rise of these beasts in the US, by far the largest market for active ETFs, was "structural."

According to Kashner, growth was sparked by the Securities and Exchange Commission's (SEC) 2019 "ETF rule," which was intended to increase industry competition by easing the process of bringing ETFs to market.

The same year, the SEC approved non-transparent and semi-transparent structures, creating another tailwind as it let active managers avoid having to reveal the complete contents of their funds daily and preserving some of their "secret sauce.”

Even more recently, certain fund companies, including Dimensional Fund Advisors and JPMorgan, converted existing mutual funds into active ETFs, which sped up the growth of these securities.

Another factor is the unfavorable tax treatment that US mutual fund investors who invest outside tax-exempt structures receive; they are taxed not only when they sell a position and must pay capital gains tax, but also when their fund is forced to sell profitable positions because other investors have left.

ETFs are exempt from the latter factor due to a structural quirk, albeit this may result in greater tax obligations when investors eventually sell.

Combined assets in U.S.-listed active equity ETFs rose by 35.5% in the first half of 2022, according to FactSet. Not counting the effects of mutual fund to ETF conversions, growth over that period was still strong at 23.1%.

“There are a lot of asset managers that have determined that the ETF is the path forward, the way of growing their business or slowing the decay of their business, so there has been a big push from the management side,” Kashner said.