Why Are Active ETFs Everywhere, and Are Investors Abandoning Mutual Funds?

Ruth Saldanha: Salesforce had a strong quarter, shares are undervalued. Snowflake had mixed earnings, but the stock is cheap. And are investors abandoning mutual funds in favor of active ETFs?

This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ruth Saldanha. Let’s get started with a look at your Morningstar headlines.

Salesforce’s Strong Quarter

Salesforce has reported another strong quarter. The cloud-based software giant’s revenue increased 11% in fiscal Q3. The automated IT platform MuleSoft, the data cloud segment, and solid execution drove more than $8.7 billion in revenue. The outlook has come in strong, especially for profitability. Large deals and growth in remaining performance obligation impressed Morningstar. Meanwhile, demand for professional services remains subdued. There was also softness in transactional type revenue and Slack self-service despite strong multicloud deals. Margins can still expand, even as Salesforce invests in artificial intelligence. The firm repurchased almost $2 billion in shares during the quarter. Morningstar is raising its estimate for what Salesforce’s stock is worth to $265 from $255. Shares look slightly undervalued.

Intuit’s Solid Top and Bottom Lines

Intuit reported solid top and bottom lines for its fiscal first quarter. The financial technology company reported revenue of $3 billion, up 15% year over year. Earnings came in at $0.85 per share. TurboTax racked up higher filing volumes than expected during the tax extension period. But because the quarter was outside the traditional tax season, Intuit’s small business and self-employed group contributed the most to revenue. Despite the results, management left its full-year forecast unchanged. Morningstar estimates Intuit’s shares are worth $500 and are currently overvalued.

Snowflake’s Mixed Quarter Results

Snowflake delivered mixed results in the third quarter. The cloud data platform company’s profits fell below Morningstar’s expectations. However, $734 million in revenue topped them. And product sales brought in almost $700 million. Execution and a stabilizing macroeconomic environment drove the solid results. Management said they hardly hear “AI” and “budget” in the same sentence. Morningstar thinks this puts Snowflake in a sweet spot as clients keep looking for an edge in technology. This can safeguard against the uncertainty that can come with a revenue model that depends on customers’ usage. Snowflake is extremely good position as the world is rapidly collecting more data in need of a place to live. It has raised its full-year fiscal 2024 revenue and profit forecast. Morningstar thinks Snowflake’s value sits at $231 per share. The stock remains undervalued and a top pick within Morningstar’s technology coverage.

What Is Driving Interest in Active ETFs?

Active ETFs have exploded in recent years. In each calendar year since 2018, they reeled in at least $25 billion and had an organic growth rate of north of 30%. In fact, at the end of October 2023, they boasted $444 billion in assets—almost triple the amount from October 2020.

So, what’s driving this interest? Ryan Jackson is a manager research analyst for passive strategies at Morningstar Research Services. He’s here today to talk about what he’s found.

Hi Ryan. Thanks for being here today.

Ryan Jackson: Yeah, thanks for having me, Ruth.

Why Are There Such High ETF Flows?

Saldanha: So what’s going on with active ETFs? Why are there such high flows?

Jackson: Sure. I mean, so like you said, active ETFs are everywhere. And I think when you look at really the rise of them, you can point to two factors that primarily drove it. First, there are just a lot more active ETFs available than there were as recently as a couple of years ago. Since the start of 2022, we’ve seen just about as many active ETF launches as there were in the 10 years leading into 2022. So there’s no doubt there’s been this huge boom in product development for active ETFs.

When you kind of point to the why behind this boom in active ETF launches, we need to go back to 2019 and look at the passage of the ETF rule, Rule 6c-11, which effectively allowed active managers to really tap into the flexibility and the tax efficiency of the ETF structure. If you talk to certain fund providers that for a long time only operated in the open-end fund world and then moved into ETFs, a lot of them will cite that passage of the ETF rule as the main reason that they brought new active ETFs to the table. And so simply by virtue of just lining the shelves with a lot more products, I think you’re going to see a lot more interest, a lot more engagement for those active ETF investors. So that’s the first part.

Second part, I think after a while, a lot of investors really just caught onto the benefits of the ETF structure. For so long, people always associated ETF and passive and didn’t realize that a lot of these great things about the ETF structure, the tax efficiency, the low cost, the transparency, could also apply to active portfolios as well. Now when you look at the growth in number of ETFs, maybe there’s a little bit of a chicken-or-the-egg story—where, was it the number of funds that prompted the demand, or was it the demand that prompted the boom?—I tend to look at really how barren the cupboard was even as recently as five years ago. And that makes me think that the real launch in all these great strategies in the active ETF wrapper prompted that demand.

Are Active Investors Leaving Mutual Funds for Active ETFs?

Saldanha: So who’s actually getting into these products? Are active investors leaving mutual funds to get into active ETFs?

Jackson: It’s a tough one. I think generally investors are leaving mutual funds for ETFs of all stripes, but of course a lot of that story is active/passive, right? It’s no secret that for quite some time ETFs have been eating into the market share of open-end funds, and very closely relatedly, passive funds have been eating into the share of active funds. Now, when you isolate that and look at just the active investing sphere, you will see that there have been pretty severe outflows from open-end funds, and as we’ve documented here, pretty nice inflows into those active ETFs. So, I think it’s reasonable to conclude that there probably are some investors that are going from active open-end funds into active ETFs, but overall it’s just a small part of that active to passive and open-end fund to ETF story.

Advantages of Active ETFs

Saldanha: So, tell us a little more about that. What are some of the advantages of active ETFs versus mutual funds?

Jackson: Sure. So if we look at the ETF wrapper, I think the advantage to start with would be that they’re generally lower cost. Now, a lot of people, like I said, associate that with the idea that ETFs and passive strategies have historically gone hand-in-hand, and passive strategies do tend to be a lot more cost-efficient to execute. But even when you narrow the scope again and look at just active ETFs versus active open-end funds, active ETFs still in many cases have that cost advantage. The ETF fees really just reflect the cost of operating the fund. But when you look at open-end fund fees, they incorporate not only that management expense but also some distribution costs, marketing, a whole other range of things that bloat those open-end fund fees.

I think a good one to point to there, a real apples-to-apples comparison, would be T. Rowe Price Blue Chip Growth ETF. This is a strategy that existed in open-end form for a very long time. The ETF recently launched, and it charges 14 basis points less than the cheapest share class of the open-end fund. So, it’s a good testament that oftentimes when you’re looking at ETF versus open-end fund, the scales are going to tip toward ETF in terms of cost.

Another big one that I hinted at earlier would be that tax efficiency of the ETF wrapper. This one I think really came into focus after 2022 because that was a year where we saw a lot of open-end funds pay out capital gains in a year where they actually lost value. Meanwhile, ETFs generally do not pay out capital gains. And if they do, they tend to be a lot smaller. So I think after last year when you had some open-end fund investors saddled with the tax bill in a year in which their strategy actually lost value, that kind of stuck in their craw a little bit and boosted the case for active ETFs.

Transparency would be another one. Open-end funds, when it comes to disclosing their holdings, tend to do so on a monthly or sometimes even quarterly cadence, whereas ETFs in many cases are going to reveal those holdings on a day-to-day basis. I’m not saying it’s always a good thing for investors to be fanatically focused on what their ETF is holding day to day, but this one really resonated with the advisor community. I think it’s a nice advantage for them when talking with clients to be able to say, “Hey, here’s how much of this stock you own. Here’s which ones you don’t” really facilitate those relationships and has made them popular among advisors.

And then accessibility would be the other one I would point to for ETFs. A lot of open-end funds, especially those that are highly sought after or have been around for a long time have pretty steep investment minimums. Whereas for ETFs, really all you need is a brokerage account, and in most cases, just a couple hundred bucks to buy an ETF share. So as we’ve seen the investor demographic start to trend a little bit younger, perhaps a little bit lower income on the heels of the pandemic, ETFs have definitely been the vehicle of choice for those investors.

Disadvantages of Active ETFs

Saldanha: That makes sense. On the flip side, what are some of the disadvantages of active ETFs versus mutual funds?

Jackson: Yeah. Comparing ETF and open-end fund, the number-one drawback to the ETF structure to point to would be that they can’t close their doors to any new investment. So that can lead to some potential capacity issues. The idea here is some open-end funds, if they feel like they’re growing a little bit too large to efficiently execute the strategy they want, maybe they’re dealing with some illiquid stocks that might move against them, they can basically shut off all new investors and say, “Here’s what we’ve got. Here’s what we’re rolling with. This is how it is moving forward.” ETFs don’t have that luxury. They cannot close. So we haven’t really seen it so far in many cases, but it could be an issue down the road if they get a little bit too large that they’re forced to settle for less than ideal execution or maybe some next best ideas to move into. That would be the main one.

Another thing to point out would be that some ETFs can’t always reach the same investments that open-end funds have access to. These instances don’t pop up very often, but one example would be that a lot of open-end funds have the flexibility to move into certain private company investments. That’s something that ETFs can’t do. So if that’s a central part of an open-end fund active strategy, an active ETF clone wouldn’t be able to do quite the same thing.

Generally, these drawbacks haven’t really reared their head too much thus far. But these are things to keep in mind when you’re thinking about ETF versus open-end fund.

How to Decide Between ETFs, Mutual Funds, or a Passive Strategy

Saldanha: So tell us that: How does an investor decide between an active ETF or a mutual fund or even a passive strategy? What should they keep in mind?

Jackson: Yeah, I think when comparing, “Do I go ETF or open-end fund?” taxes should be a very central part of that consideration. Not only the rates of tax that you’re going to be paying but also, “Where is this investment sitting?” If it’s sitting in a taxable account, that might tip the scales a little bit more toward ETFs, if you’re kind of having a 50/50 decision to make. But if it’s something like a 401(k) and it’s only available in an open-end fund, that’s not too much of a drawback. That’s a tax-advantaged account. And that separation between ETF and open-end fund really won’t be that pronounced for those that are sitting in tax-advantaged accounts.

But even more than that, I would just remind investors that when you’re thinking about making a new investment, the strategy should come first. I think it’s more important to focus on, “What kind of investment strategy do I want? Am I convicted in it?” And then secondary should be, “Is it sitting in an ETF or an open-end fund?” Something we always say is: The best strategy is one you can stick with. If you’re settling for an ETF and a strategy you don’t really love just because it’s an ETF, there’s a good chance you might be selling it at an inopportune time, not reaping those returns that you would be if you just stuck it out. So strategy first, but I guess as a tiebreaker or still an important consideration, ETF versus open-end fund can come into play then.

Saldanha: Thanks so much for being here today, Ryan.

Jackson: Yeah, my pleasure. Thanks.

3 ETFs That Benefit From Higher Interest Rates

Saldanha: Though it has felt for a while now that a federal-funds rate near 0% is normal, history tells us that near-zero interest rates are in fact very much not the norm. In fact, prior to 2007, there were more months with a federal-funds rate above 15% than there were below 1%.

With interest rates likely to stay on the higher side, investors should realize that there is money to be made here. Bryan Armour is a director of passive strategies for Morningstar Research Services, and he is also the editor of the Morningstar ETFInvestor newsletter. He has three ETF picks for investors looking to make money through higher interest rates. Here are his choices.

Bryan Armour: Interest rates were extremely low for a long time. So long so that a federal-funds rate near 0% felt normal. Foreign sovereign debt was issued with negative yields; Austria even sold a 100-year bond with a 0.85% coupon that matures in 2120. However, history tells us near-zero interest rates are far from normal.

Since 1954, there have been 123 months where the effective federal-funds rate was below 0.60%. All 123 observations came after 2007. Prior to 2007, there were more months with a federal-funds rate above 15% than there were below 1%. That is to say, the current rate of 5.5% is high but not even approaching historical extremes.

Since the Fed began hiking interest rates in earnest, bond traders have continuously had to push back their predictions of when the first rate cut would take place. The Fed remains hawkish. The jobs market continues to run hot. U.S. GDP has beaten forecasts. Investors don’t need to fight the Fed—there is money to be made should rates stay higher for longer. Today, I share three ETFs that can do just that.

First, it should come as no surprise that bonds perform better when rates are higher. Not only are yields higher, but rates are more likely to drop at current levels, which would benefit bond prices.

For that reason, the first ETF on my list is iShares U.S. Treasury Bond ETF, ticker GOVT. There’s no need to bet on short- or long-maturity bonds: GOVT gives you access to all maturities. This is a balanced approach that will keep interest income churning for years to come, regardless of what happens to interest rates.

Another winning higher-for-longer strategy is quality. High-quality stocks have proven resilient in all interest-rate environments. That’s why the second ETF on my list is Invesco S&P 500 Quality ETF, ticker SPHQ. SPHQ favors stable, profitable companies over those that rely on debt financing or that aggressively grow their assets. It ranks S&P 500 companies by their quality score and picks the highest-ranking 100. It weights selected holdings by a combination of their market cap and quality score, steering the portfolio further toward quality while also tying weights to market prices. Quality tends to come at a premium, but SPHQ stays well-grounded. It’s among one of the highest-quality ETFs we rate, but it still maintains its spot in the large blend Morningstar Category, not large growth like other top quality strategies. This is important because—spoiler alert—value tends to outperform growth when interest rates move higher. SPHQ gives investors the best of both worlds—high quality without a heavy growth tilt. That’s one of the reasons its return has ranked in the top-five percentile funds in its category over the past 10 years and should continue to be a winner for investors.

As the spoiler alert foreshadowed, my final ETF focuses on value stocks, while also tapping into higher-quality companies than most value peers. Avantis U.S. Large Cap Value ETF, ticker AVLV, looks for companies that are both cheaply priced and profitable, selecting the top 25% of U.S. stocks based on the combination of those two metrics. AVLV’s portfolio looks unconventional in some ways. It can hold growth stocks if their profits justify their relatively steeper multiples. For example, Apple AAPL has landed among the fund’s top 10 largest holdings since the fund’s launch in late 2021. But it still retains an emphasis on cheaper companies, with its average valuation tending to fall below its average large value Morningstar Category peer. AVLV has a short but successful track record, beating the Russell 1000 Value Index and its average large-value peer since its 2021 inception. Its combination of value and profitability should pair well with interest rates that stay higher for longer.

Saldanha: Thanks, Bryan! That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos from our team. You can hear market trends and analyst insights from Morningstar on your Alexa devices. Say “Play Morningstar.” Thanks to senior video producer, Jake VanKersen and video producer Daryl Lannert.

And thank you for watching Investing Insights. I’m Ruth Saldanha, Editorial Manager at Morningstar Canada.

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