MSCI’s Eye-Opening Study on Active ETFs

Wall Street, financial advisors, regular joes, and even large institutional investors have gone ga-ga for active ETFs. While they debuted in 2010, it wasn’t until recently that active ETFs caught on with portfolio managers and the investing public. Thanks to SEC regulation Rule 6c-11, asset managers were able to explore new structures for transparency to avoid front-running. This introduced a host of new semi- and non-transparent structures that kept holdings ‘secret’ and allowed asset managers to feel comfortable using the ETF structure for active management.

Since then, active managers have launched brand new funds, created copycat fund launches of existing mutual funds, and conducted mutual fund-to-ETF conversions to go from a small handful of active ETFs in 2010 to just under 1,765 at the end of 2024. More launches have steadily occurred so far this year, with several legacy asset managers finally launching their first ETFs.

And now with many asset managers looking to exploit Vanguard’s expired ETF share-class patent, the number of active ETFs is expected to surge even further and they could overtake mutual funds in the future as the investment structure of choice for all investors.

Given the growth and sheer number of active ETFs now on the market, picking the right fund for your portfolio has become a hard task. Luckily, the number of active ETFs has finally hit a size that we start doing some real research on the funds, structures, holdings, etc. Index provider and researcher MSCI finally has some of the real first data on active ETFs. ¹

It turns out active ETFs generally fall within two distinct and polarized camps. Currently, active ETFs are either highly concentrated or broadly diversified. This chart highlights the firm’s findings on 301 different active ETFs available in May 2024 when it did its study.

 
Source: MSCI

Ok, so what does this data mean and why is it important? According to MSCI, investors may be getting the short end of the stick. That’s because when looking at a concept called active share, many of the ETFs in the broadly diversified camp are just ‘enhanced index funds.’

By definition, active share is a numerical way to track the disparity between a portfolio manager’s holdings and that of its benchmark index. The higher the active share, the more the fund manager is contributing to returns and the portfolio.

The problem is the broadly diversified camp has low active shares. That’s because they use systematic strategies that take an index and apply small active touches to the benchmark. This can include applying value screens, looking for strong balance sheets or scoring momentum and dividend yields. Managers use these systematic elements to purchase stocks or bonds to tweak an index.

For example, the very popular and $34 billion Dimensional U.S. Core Equity 2 ETF (DFAC) holds 2,664 stocks. This is just shy of the 3,000 included in its benchmark, the Russell 3000.

For MSCI, this is misleading particularly when you apply appropriate benchmarks to these active funds. Most active ETFs will benchmark themselves to indexes like the S&P 500 or Russell 2000. That will lead them to show outperformance. But if you compare them to appropriate factor indexes—which are more in line with their actual mandates and enhanced index appreciates—their returns are mixed and in some cases produce losses due to their high expense ratios.

According to MSCI, as the active ETF sector continues to grow and expand, it is paramount to understand whether a fund is truly active and could potentially deliver superior outcomes or whether it is an enhanced index in disguise. This is particularly concerning considering that many of the largest active ETFs launched in recent years have come from asset managers using these enhanced indexing strategies.

J.P. Morgan, Avantis/American Century, Dimensional Fund Advisors (DFA), Blackrock, and Fidelity have gathered billions in assets in their active ETFs that use enhanced indexing strategies.
While there is nothing wrong with these funds or enhanced indexing, investors may get more bang for their buck in the high-conviction/high-active share camp of active ETFs. A study by MIT, LSE, and Goldman Sachs showed that managers willing to make ‘big bets’ and have high conviction in a small number of stocks managed to deliver approximately 30 basis points of additional performance each month, or roughly 4 full percentage points of additional return each year than those that focused on broad ‘diversified’ holdings.

For MSCI and investors going forward, the answer may be to make sure they know what they own and understand how much active share their fund has. Enhanced indexing has a place in portfolios, but investors may not realize that’s what they are buying under the umbrella of an active ETF. So it’s important to understand strategy rather than just focusing on the fund shop and size of the fund. Digging into the ETF is the right move.

These ETFs represent some of the largest active ETFs around. They are sorted by their YTD total return, which ranges from -2.7% to 7.8%. They have expense ratios between 0.17% and 0.36% and assets under management between $5B and $30B. They are currently yielding between 0.8% and 9.7%.

All in all, the growth of active ETFs is great for portfolios. But it comes with some pitfalls. ETFs are quickly falling into those with real active share and those that index huggers/enhanced index portfolios. This was the folly of, and follows many, mutual funds. Finding the right fund for what you need is now a major issue and investors can rubber stamp their purchase.

Active ETFs have continued to see torrid growth. But now, questions about their outperformance are starting to be asked. The latest MSCI study shows that active share among some active ETFs is very low and, in that, investors may be paying for simple factor indexing in disguise.

¹ MSCI (January 2025). Unpacking Active ETFs