ETFs Explained #6: The active ETF growth in the US

The first actively managed ETF was launched 15 years ago, but adoption in the US accelerated only post-2019 after the SEC's regulatory change. The so called "ETF rule" (rule 6c-11 under the Investment Company Act of 1940²) supports active ETFs by reducing regulatory barriers, enhancing transparency, and boosting operational efficiency by:

• A standardised regulatory framework cuts costs and lets ETFs, including active ones, launch without waiting for SEC exemptions.
• Transparency and disclosure requirements include daily portfolio transparency, publishing daily net asset value and providing bid-ask spreads – the gap between the buyer's offer and the seller's asking price.
• More efficient portfolio management by allowing the use of custom baskets for creation and redemption of ETF units.

Since the rule came into effect in 2019, active ETF numbers and assets under management have risen. Active ETFs' share of total ETF assets in the US has climbed from 2.8% in 2019 to 8.5%¹ by the end of August 2024.

North America active ETF growth

Source: Trackinsight Data as of 31.08.2024, includes ETFs only and excludes other exchange-traded products (ETPs) such as exchange-traded notes (ETNs) and exchange-traded commodities (ETCs).

ETFs are generally more tax-efficient than mutual funds due to lower turnover and fewer capital gains distributions. This is particularly beneficial for US investors. Capital gains are profits from asset sales that investors must pay taxes on, even if they haven't sold their investment. This tax efficiency arises because:

• Investors mostly buy ETFs on exchanges, so issuers don't need to frequently buy or sell underlying holdings, resulting in lower turnover.
• In the primary market, ETFs may use in-kind transactions, where securities are exchanged for ETF units, to create or redeem units, reducing transaction costs and potentially avoiding taxable events.
• Issuers execute transactions through intermediaries, consolidating them into fewer net transactions.
• During redemptions, lower-cost securities may be moved out without tax, leaving higher-priced securities. This can potentially reduce future tax liability.

These benefits apply to both passive and active ETFs, and investors still face capital gains taxes when they sell ETFs, just like any other investment.

Percentage of funds paying capital gains in calendar year

Source: Morningstar, J.P. Morgan Asset Management. Cost basis is the original purchase price used to calculate capital gains and losses. Capital gain is the profit, if any, on a security that has been sold (sale price minus cost basis). Data as of 31.12.2023. Shown for illustrative purposes only.

Changes in US distribution models are boosting demand for active ETFs. Digital wealth platforms, offering a wide range of strategies without minimum investments and at competitive prices, have grown rapidly.

Additionally, the shift from brokerage fees/commission to a fee-for-service model has led advisors to focus more on investment outcomes, increasingly incorporating active ETFs into client portfolios.

Today, North American investors have access to over 2,300³ active ETFs covering most types of strategies and asset classes. Investor adoption has accelerated with the evolution of the vehicle, allowing investors to use active ETFs for core portfolios and risk diversification.

Some issuers have converted existing mutual funds to ETFs to spur demand. While only about 5%⁴ of active ETFs are conversions, four³ of the largest 10 active ETFs were mutual funds previously. Several asset managers have also sought SEC approval for an active ETF share class of their mutual funds. Approval will allow them to package the mutual fund strategy into an ETF structure as well. This will enable the mutual fund share class and ETF share class to coexist and provide another way for investors to access successful mutual fund strategies.

The rise of active ETFs marks a significant evolution in the investment landscape, driven by regulatory changes, tax efficiency, and shifts in distribution models. As these trends continue to gain momentum in the US, they are setting the stage for similar growth in the APAC region.