Global Perspectives: The rise and role of active ETFs in modern portfolios

Matthew Bullock: Hello and welcome to the latest recording in the Global Perspective podcast series. My name is Matthew Bullock. I’m the Head of Portfolio Construction and Strategy for EMEA and APAC, and today I’m joined by two guests.

We’ve got MJ Lytle, Head of Product Innovation, and Stefan Garcia, Head of EMEA Specialist Sales. Hi guys. So, I’m just going to start with you because I spend a lot of my time going out talking to clients about how they’re building their portfolios, what they’re using in their portfolios.

And when we get to the point about what they’re using, they use lots of funds. They use direct assets, they use investment trust, but they also use a lot of ETFs. And what’s been coming up a lot, especially in the last six to 12 months, has been active ETFs. And so, one of the questions that I want to go right to the very basics here is what exactly is an active ETF? And how is it different from a traditional passive ETF?

MJ Lytle: So, I think you’re getting at the point, that clients need tools to make investments to implement exposure that makes sense to them, given their views on the market. People say active ETF, passive ETF, they suggest that ETFs are traditional passive. What they’re saying is that within that traded Undertakings for Collective Investment in Transferable Securities (UCITS) wrapper, people have tended to put passive strategies.

And there are very good reasons historically for why this has happened. If you look at the businesses that develop the ETF business over time, they came from a systematic investment banking background. And so, the natural thing that they were looking for, they had a traded UCITS wrapper. What would they put into it? The thing they were good at, which was systematic investing.

What’s been happening in the last few years is that people said, well, do we need to be constrained by indices in what we put into an ETF wrapper? No, absolutely. We don’t. Can we put active strategies? Well, you know, can we put strategies that have an alpha component in them? Absolutely. What does putting that alpha component into the wrapper do for clients?

Now, if clients believe in the active component, it does great things for them because it gives them [the potential for] outperformance. But that’s the key. Can you deliver them something where the promise is delivered, and it therefore continues to meet their investment needs in the wrapper?

Bullock: So okay, so I said about how clients are starting to ask more and more questions. And by itself, MJ and Steph have been involved in active ETFs with us for quite some time. There’s been an explosive growth in the active ETF space, especially in Europe. What would you say are the sort of key reasons that’s driving that momentum right now? Stefan if you want to start us off.

Stefan Garcia: Okay. So, a couple stats, which I always like to start off with. The market’s grown from, you know, US$50 billion at the beginning of this year to US$75 billion now. And so that’s 50% growth and is projected to grow at 100% a year plus for the next few years by some certain large houses. It’s about three things that I always say ultimately: It’s accessibility, it’s liquidity; and it’s tradeability.

So, accessibility, the access ultimately, as MJ pointed out. It’s traded like an equity. So, it’s available on multiple European stock exchanges. All the big stock exchanges and different currencies and hedge currencies. And so, clients, especially clients in the digital wealth space, in the private wealth space, are able to access these just like an equity, in terms of liquidity. The authorised participants and the liquidity providers and the banks are the brokers that that operate in the space.

You know, there’s a universe of probably 30, 40, 50 firms in Europe that provide that liquidity. Just like an equity. And ultimately, it’s about transparency. People want to see their holdings and they want to see them real time. And I think that for, for, for older wrappers, they’ve had to wait, whether it’s a week or a month or, you know, in other places that are less liquid, in this case, they can see exactly what’s in the portfolio, you know, 24/7.

Lytle: Can I just. So, this creates an opportunity and a challenge, the opportunity is that people can purchase something, that they can see exactly what it’s doing. All the time, which is fantastic. You can go on a website. You just have to go into a Google search, put in the ticker immediately pops up, information which you don’t get with traditional funds.

The challenge is that they’re not necessarily used to using a brokerage account to purchase the assets in their portfolio. They’re used to giving money to asset managers and using the funds, pipes to do that. So, for clients who have not traditionally used a traded wrapper, they now have to build some back end for them to be able to do that.

Now, I think the market is working very hard to deliver, liquidity both on exchange and off exchange through platforms like Trade Web and Bloomberg etc… But it does mean for some clients who’ve had a certain way of booking their exposure to funds, it is a different, challenge. And so, they do have to build some stuff.

Bullock: So, I know both of you have done quite a lot of research, around the use of active core ETFs, especially how they replace and replace passive to such a large extent. And if we think about the current market environment and that will the investment we’re heading into, which is a lot of volatility, a lot of uncertainty, it is kind of the place really for active to really stand up.

But one of the things that also comes up is whether investors should be looking at replacing existing fund holdings and mutual fund holdings with an active ETF. And so, what I wanted to get around was what are the advantages of both of those sorts of approaches, because is there a right answer or is it actually case dependent?

Garcia: Well, I think we should, you know, step back a little bit. And so, in an environment that we lived in, let’s say up until a few years ago, low-interest rate environment, I think there, there was a lot of money that went into passive exposure. So, things like the S&P 500, I think that as, ETF providers have evolved their offering.

I think that as active shops have evolved their offering, I think you’ve got two other options now and you’ve got, and I know MJ will dovetail on this one. You’ve got index plus or research enhanced strategies. And so, I think the first step away from just a passive exposure like the S&P 500 was, hey, we’re going to give you something new.

We’re going to try to outperform the S&P 500. And we’re going to try to, you know, give you something that’s within, let’s say 1%, of tracking error. I think the next phase of that development is, hey, we’ve actually got stuff that is probably, you know, a little bit spicier, a little bit more fundamental. It’s something with a very, very long, you know, exceptional track record.

But it might have 3 or 4 or 5% tracking error or it might want to, you know, properly outperform the S&P 500. And then it’s new kind of geopolitical and interest rate world. I think that people are looking to use some of those exposures, whether it’s tactical, don’t know if it’ll replace the core exposure like an MSCI Europe.

But I think in some cases there are they are looking for outperformance. And I think that there are certain shops and certain funds that can deliver that.

Lytle: Yeah, I mean, I think active high conviction, and active core are going after two totally different things. Active high conviction is not going to replace passive strategies, because they’re apples and oranges.

Right. Active core, which is basically an ‘index plus’ approach, where you basically say: “I can deliver you index plus a degree of alpha net of fees”, you’re still going to be performing better than the index. That is a potential replacement for your index investment, because it has a high correlation to the beta of the index, but it gives you a bit more.

I also think that active core between equity and fixed income is two quite different things. So, in the equity space it’s about can I give you a little bit more net of fees and therefore you’re just better off in the fixed income space. It’s about the fact that fixed income is not an easy to index base. It’s a complicated asset class.

There are many, many more securities, nine million fixed income securities versus 70,000 listed equities. It’s much more complicated to use a machine to determine what should be in a benchmark, but the data around the securities is much worse. You know, you just don’t have, pricing information on the securities, live and ticking because they just don’t trade every day.

So having a human being helping you to effectively create index exposure, it will open up a lot more of the fixed income spectrum that otherwise just was not deliverable through traditional passive index techniques. And so, if you look at the ETF space today, which is about 65% equity, about 25% of fixed income, which is not the proportion that they represent in the global asset markets, where fixed income is actually a bigger asset class than equity. I think this is the levelling up opportunity between the two asset classes.

Bullock: So, if just going back to the original question, where and I get this question quite a lot from investors trying to make that comparison between the active ETF and the mutual fund. Is there sort of an easy way of trying to make a distinction between those two?

Lytle: Well, they’re both UCITS funds, right. So, a lot of people started out by saying, well, what about the UCITS fund versus the ETF? It’s an UCITS fund. It follows all the same guidelines. Simply the process for entering and exiting the fund is through a trading in the secondary market for all investors. They then that’s translated by APs (Authorised Participants) into the primary market.

But fundamentally if you want to invest in a traditional unlisted UCITS fund, you do it through actually directly primary doing transactions into the fund, whereas in the ETF space you’re trading in the secondary market against that fund. So, you know, that is the only real difference. That’s why when people say, oh, these are passive vehicles, well, there’s nothing passive or active about these vehicles.

It’s about what do you use them for? And what does that trade characteristic. Due to the complexities of delivering the exposure.

Bullock: And do you do you see when you’re out there talking to clients about the active ETF space? Are they sort of now looking at the composition of their indexes? Because we have seen especially the S&P 500, a really big concentration now in a small number of names. So are they actually coming looking for more. They’re not looking for just index replication. They’re looking for something that isn’t looking the same or active the same as an index.

Garcia: Yeah. So, I actually wanted to go back a little bit because MJ you know, but I think something quite important and you’re asking like okay so let’s give us a concrete example.

Let’s say global high yield. So, somebody will put out a search and they’ll spend a couple of years trying to get to know all the different high yield global high yield managers out there. And you know, when they finally make a large allocation, let’s say they’re a large institution. They might pick an active manager, right, in a mutual fund wrapper or in a mandate wrapper.

But they are now not just passive high yield ETFs, but active high yield ETFs. And there will be moments along, you know, you know the path where they’re going to need to either overweight or underweight that exposure. And I think that both can, you know live symbiotically. And ultimately, it’s about tools and it’s about access and it’s about trade ability.

Lytle: It’s about that speed to market. So, if you want to trade high yield, if you have to call up an active manager, do due diligence and then transfer them the money. Right. That is a very different investment experience from going on exchange, looking at the ticker for a high yield ETF and putting the money in and getting instant immediate exposure to the market.

Now, you may decide that that ETF, which it might be delivering a passive or index plus exposure is not where you want to be long term, but at least it gives you access to that market right now when you have the view that it’s an opportunity. So, there’s also quite a different dynamic for how investors think about the time frame for their investment.

When they’re looking at ETFs, they are obviously often times when you’re having a sales conversation with a client about an ETF, you’re having a conversation about something they want to do now.

Garcia: There’s also opening up I mean you ask question about like opening up new markets or opening up. So, let’s just say securitised right. And let’s say Collateralised Loan Obligations (CLOs).

For example, clients might take a couple of years to get their heads around what is securitised. What are the different areas? Is it mortgage-backed securities? Is it something else? Is it close. You know, in in this case, you know, we’re talking about triple close. And we’ve been able to launch very, very successful, you know products. And we’re the global leaders in that space.

And it allows people to start to better understand something with a triple A exposure and gain exposure to a new asset class. And I think that’s where they’re quite helpful in a tradable vehicle that they can get in and out of instantly. And if they like the exposure grade, if they feel that they need to get out of it because something is happening in, you know, in markets, they can get out of it very, very quickly.

Bullock: And so going back to when I talked about the differences between mutual funds and active ETFs, and, and your response, MJ was how similar they are. So, based off that, what are some of the misconceptions that investors may have or barriers that are stopping them? And I think you sort of touched on this before about how they trade with it. But what are some of those barriers that are stopping people from going around active ETFs? And then second part of that question is how is that being addressed?

Lytle: I think some of the barriers are intellectual because they think this is something totally different. So, I’ve got to spend a bunch of time, considering how I’m going to deal with it.

Right. So, they see it as a, as an intellectual challenge to figure out where to put it in the portfolio as opposed to just a practical. “Oh, great. I’ve got another tool to use in my portfolio.” I think what I mentioned before around the operational challenges, if you don’t have a trading book, you know, if you don’t have a brokerage account, it can just be a problem.

You know, if you look at UK MPS investors, they have a fundamental problem. We often launch unlisted share classes of our ETFs simply so UK MPS’ can purchase because they don’t have the brokerage account. Right. And that seems, you know, why would you do that. It’s a practical thing. You know this is 50% of providing product to clients is listening to how their business actually works and delivering them something that they can use today to solve a problem that they have. Right.

So, I think that we also have to consider the main point around the ETF toolkit is that the individual tools don’t change much when they’re passive, right? When they’re an S&P 500 passive tracker. And you come to me, and you talk to me about that ETF today, and then you come back to me a year from now, you say what’s changed? Nothing. Right. Nothing’s changed. But literally we don’t need to have a conversation. If you have the ticker you know. Do you want an update on the bid offer spread? What would you like with the size you can trade in, you know, whereas with some more active funds, you know, clients want to come back and ask a bunch of questions.

Okay. Well, so how is it performed over the last six, 12 months? How’s it changes? What are the views of your portfolio manager (PM)? Have they changed? Have they skewed what they’re investing in? Have they dropped names, blah blah blah that because the investment evolves over time and so you kind of have to get an update. So again, the difference between the active core and the high conviction is the active core should not change.

It should, like the passive, remain basically the same. So, once you’ve done your work and understood what you’re going to buy, you’re done. Right? Whereas on the high conviction there is conviction in there, there’s differentiation. There’s a meaningful alpha and volatility component versus the reference benchmark. You do need to get an update, right. Because you’re asking for an alpha component. And you got to see that it’s actually going to be there.

Garcia: And I think to the third point there. So, I would see that’s education. And ultimately the industry in Europe and everywhere has kind of grown on the back of specialist salespeople, people that were involved early in the industry, people that know the ins and outs. And I think that’s a good point.

When you have active strategies, I think it’s more frequent updates. It’s interaction with the client, which also manages its interactions with the portfolio management team, understanding the positioning, understanding the reweighting and the rebalancing. And I think that part needs to be needs to be expanded by everybody in the industry.

Bullock: So, if you look for then to, we’ve talked about a need for education. So, let’s assume that education’s already happening. But let’s assume that that continues, and the momentum is still there. So, in the next three to five years if we’re thinking about how portfolios are constructed. Stefan, maybe if I start with you, how do you sort of see portfolios evolving with the use of active ETFs?

Garcia: So, you know, another great example. You know, we’re sitting here in September and a lot of people in Europe are benchmarked either to the MSCI Europe or the Euro Stoxx 50 or in some cases the Dax or the COC or whatever their domestic benchmark is. I think that, you know, with the right size and the right track record of certain active ETFs, and we’re talking about high conviction active ETFs.

You’re not researching enhanced or kind of low tracking products. You could be in a position where you have, you know, five providers out there. You have the research enhanced ones. You have the high conviction ones out there, somebody who’s got a great track record. You can look through the portfolio. You know, the product is a certain size. You know, it’s trading a lot, and you can take a tactical view because you feel that you need to outperform MSCI Europe or Euro Stoxx 50 before now and year end.

So that’s a great example of a use case for a high conviction strategy. And right now, there aren’t very many options out there. And I’m assuming in a couple of years’ time there will be more options. And that’ll be done across a lot of the different equity benchmarks. And hopefully, you know, even in the in the fixed income space where I agree with MJ, there’s just a lot of room to grow and a lot of ways to deliver additional sources of yield, especially in fixed income in an active format.

Lytle: Well, and fixed income, you know, he said we have more yield today, but in some countries we don’t. In Switzerland, the Swiss National Bank (SNB) cut rates to zero. Right. And so, clients are struggling to find ways to get yield in their portfolio. One way is to identify new sleeves like, you know, close, Triple-A, close. Other, asset-backed securities (ABS) might offer them a pickup that, you know, structurally offers more yield through bigger spreads, with limited, credit exposure.

But also, they may want to give some discretion to managers to try and produce alpha to, to make up for a lack of yield. And I think that’s where we’re going to see more high conviction in the fixed income space when people are basically saying, well, you know, 1% in, in Swiss francs, not so interesting. What can you do for me to get me to 2%, 3% or 4%?

Because, you know, it’s not like inflation. Zero. I’m basically going backwards, if I’m at that kind of low yield. So, I think that there, there’s room there for a lot, you know, the number of tools that we’re giving to clients to be able to make adjustments, to improve the portfolio performance, is only greater with these components of both active core and active high conviction.

And so therefore the toolkit is going to look more and more interesting to clients. I think the challenge and we’ve seen a deluge of new issuers coming into the space just to do a handful of their best active strategies. Right. And that’s going to get very complicated for investors to just have a slew of new issuers who only have a couple of ETFs.

They don’t really deliver a full supported capital markets toolkit. They just want to get some of their ideas into an ETF wrapper, to see whether these products are actually working efficiently as an ETF offering, because it’s not a given. You can’t just take any strategy, drop it into an ETF wrapper and assume it’s going to work well. There’s a lot of effort and energy that goes into supporting these products to make them traded, type bid offer, on exchange, OTC you know what they’re supposed to live up to.

Well, that I mean, that takes us neatly to my last question, because we’re almost out of time. But I see, MJ, you only started to answer that question already, which was if an investor is now going, okay, I’m, I’m looking at active ETFs, but what are the key things I need to look out for when I’m looking at all the different providers out there?

So, what advice can we give them to sort of help them go down that path? Stefan, do you want to start us off and then MJ finish?

Garcia: I mean, look, all the basics of when you look at ETFs, obviously look at size. If they’re high conviction, you want to look at track record. You want to look at the team.

You want to look at recent clearly performance as products grow. And we’ve got a couple that have grown relatively quickly. You want to look at, trading volumes to see if they’re increasing. You want to look at underlying holders, if you can see them. And if there’s transparency on Bloomberg to see maybe who else is using the ETF and how, you know, trading spreads, you want them coming down.

So, I think all of those basic things. But then I also think that you need to look at that, you know, within a let’s say a big active shop. And I agree with MJ that you’ve got a lot of shops out there, big and small boutiques that just want to take their best strategy and put it in into ETF.

Ultimately clients, they can’t handle 500 ETF providers in Europe. They want to deal with a handful, and they might want to deal with five or 10 very, very large ones on the passive side, they compete on fees, and they can take an S&P 500 from, you know, originally 20 basis points (Bips) down to five Bips down to three Bips down to two Bips.

And then possibly, you know, five, five houses on the active front that give them a toolkit because it’s very, very hard to monitor all of this and monitor performance and all of these other product features.

Lytle: I think clients should ask about the resources that the manager they’re talking to are actually putting into the ETF space, because it’s not something you can do with three people. Right. You know, obviously we were purchased by Janus Henderson last year (2024). We had a business of 20 people. We’d spent six years developing that business. And, you know, it does take a lot of time and effort and energy.

Some of our competitors have thrown scores of people at it, and they’ve done a good job and really invested. I think you need to look very carefully at whether the business is actually going to deliver you a good ETF experience, right. They may be a very good asset manager, but have they really invested in the exchange traded space to make sure that they’re supporting that product. Because you can’t just do what you do with the launch of a traditional fund, which you drop onto all funds and now is available to everybody. Push the button, right. There’s a lot more to it than that.

Bullock: MJ, Stefan, thank you both very much for all of those, responses. And also, thank you to our audience for listening.

So, if you do have any questions about Janus Henderson’s investment views or you wish to have or you have any other questions at all, please don’t hesitate to contact your client, relationship manager or visit our website.

So, with that, thank you very much for listening and I wish you a very pleasant rest of the day.