Why Active ETFs Are Gaining Momentum as Investors Seek New Solutions

We spoke with McCarthy about the outlook for active ETFs, including derivative income and defined outcome offerings that help investors achieve specific financial goals. He also provided insight into the growth of active fixed-income ETFs and the next frontier—private asset ETFs.

Active ETFs have been around for years. Why are they becoming so popular now?

Both retail and institutional investors love the three fundamental benefits of the exchange-traded fund structure: accessibility, transparency, and affordability. But active investing was largely left behind in the ETF evolution.

Now clients are ready for more. Many are not content to just capture beta, or market-tracking performance. Many ETF investors want to seek market-beating returns, which we like to call alpha. They also want to use ETFs to potentially solve for portfolio challenges, including income generation and mitigating risk.

Is this why investors are turning to more sophisticated active ETFs?

Yes. Derivative income ETFs and defined outcome ETFs are two fast-growing categories. They have some similarities in that they both use options to solve specific investment challenges. But they differ significantly in their investment objectives.

Investors, for instance, increasingly want to achieve financial goals with a greater degree of certainty and with the cost efficiency they expect from ETFs. This includes the goal of generating reliable streams of income.

Derivative income ETFs are designed to fulfill this goal and maintain some growth potential from equity exposure. Working-age investors can use them to supplement their regular form of income, while retirees often use them as a replacement for their paychecks.

Defined outcome, or buffer, ETFs are designed to manage downside risk while maintaining some equity market upside. These funds have become a popular way to protect investors from market downturns.

By using options, the ETF can provide a predetermined buffer to prevent the fund’s value from dropping below a set level. In exchange for this degree of certainty on the downside, investors are capped on their upside participation. These products have become increasingly popular among investors looking to manage risk.

Shifting to active fixed-income ETFs, why did it take so long for this segment to gain traction?

When you look at the ETF industry, fixed-income assets are still dwarfed by equity offerings. I think part of this late adoption reflects the more nuanced nature of fixed-income markets’ structure and fund managers generally taking longer to become comfortable offering their strategies in the more transparent ETF structure.

Similarly, it took clients some time to embrace the mechanics of fixed income ETFs, specifically around pricing and liquidity in markets that are inherently less transparent than equities. This has all changed as both fixed income managers and investors alike have embraced the ETF wrapper, and what is really exciting is the opportunity it creates for active management in the space.

Does the nature of the fixed income market lend itself to active investing?

Absolutely. Liquidity and liquidity providers have historically been quite fragmented in the bond markets. When you consider how bonds are sourced and traded, active managers can add value by how they manage relationships, source inventory, and ultimately execute trades.

Generating alpha doesn’t just come from the expertise around picking bonds; it is also delivered by the ability of managers to access those bonds. The nuances across investment-grade credit, high-yield bonds, municipal bonds, and rates are quite different. Navigating these sectors takes experience and skill.

Delivering these exposures within the ETF wrapper is a continuing evolution that plays directly to the strengths of active management.

Have fixed income ETFs changed the structure of the market?

I believe they have. This moment reminds me of earlier in my career when I was an equity trader, running around the trading floor buying one stock at a time. Fast forward to today and now investors can, at the click of a button, gain exposure to hundreds or thousands of stocks around the globe via a single ETF. We see the same pattern evolving in fixed income.

An investor doesn’t want to have to go and buy 500 bonds, they want to buy one ticker. As fixed income ETFs have grown, this has forced dealers to build the technology and connectivity required to buy and sell hundreds or thousands of bonds at once.

It wasn’t that long ago that this technology didn’t exist. The improvement in market structure not only allows for further product development, but it also enhances liquidity, tightens spreads, and ultimately leads to better investor outcomes.

So, what comes next in the evolution of ETFs?

Well, it’s early, early days, but private assets is an area that ETF technology has yet to really disrupt, and there is an opportunity to provide more diversification with these types of offerings. There is a lot of work to be done to see how ETFs can provide solutions in private markets. Remember, private assets tend to be illiquid and yet ETFs are, by design, highly liquid. So, investors will want to understand how they can access private asset returns given this liquidity mismatch.

One innovation we are excited about is investable indexes that aim to leverage extensive data and deep expertise in quantitative investment strategies to generate private equity-like returns through publicly traded securities.

When you follow the ETF story, you see how this technology has changed the market structure in a variety of asset classes: equities, fixed income, derivatives, and next is private. Along the way, the product’s three central tenets—accessibility, transparency, and affordability—are as valuable as ever, whether you’re an individual investor, an institution, or an investment adviser.

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