For what seems like years, passive investing has held the portfolio crown. Thanks to the creation of exchange-traded funds (ETFs), investors, advisors, and model builders flocked to index funds, quickly building inexpensive beta exposure to broad market themes. Thanks to low costs and strong market returns, passive funds have handily beaten active management. The debate between active vs. passive management seemed to be settled.
Then came active ETFs.
Now, the dynamic and ever-shifting market could be a call for investors to use more active ETFs in their portfolios right alongside their passive funds. Overall, this combination of the two strategies could be the best for the current and future market environments.
Passive Takes The Lead
Jack Bogle technically didn’t invent index investing, but when he launched Vanguard in the 1970s, he brought it to the masses and popularized indexing with regular retail investors. Since then, passive strategies have taken the world by storm. Exchange-traded funds (ETFs) and all their various benefits- including rock-bottom costs helped exacerbate the trend further and push low-cost beta exposure to the forefront of portfolio construction.
And dominate, it has.
Looking at Morningstar data, back in 1989, index funds worldwide contained only $11 billion in assets. At the end of 2021, index funds worldwide had a whopping $17.3 trillion in assets. That’s more than a 1,500-fold increase from those 1989 levels and represents more than 32% of all investment dollars. 1
The explosion and proliferation of passive ETFs have continued today. For example, the four largest ETFs, each of which tracks the S&P 500, managed to pull in more than one-third of all equity inflows in 2024.
And given the overall surge of the equity markets over the past decade, cheap beta exposure has been a preferred choice for portfolios.
Active Fight Back
But just as the active vs. passive debate seemed to be settled and indexing winning the war, active management has bounced back. Again, thanks in part to ETFs.
It turns out that active management can and does beat passive benchmarks. However, many managers have historically struggled to beat the fees charged by the fund enough to recognize those extra returns.
Thanks to new active ETF fund launches and mutual fund-to-ETF conversions, fees for owning active management have started to come down significantly. The average expense ratio for active ETFs now sits at around 0.44% and some cost less than even passive funds. That is dirt cheap when compared to the 1.5%+ rates investors used to pay for active management in mutual funds a few years ago. With a lower fee hurdle, managers can make the most out of a half or one basis point beat over an index.
Then there are taxes and the elimination of cash drag. Thanks to ETFs’ structure with primary/secondary markets, ETFs have continued to support tax efficiency with active management and have allowed managers to be fully invested rather than hold cash cushions. Both factors have only enhanced active’s ability to outperform passive benchmarks by even more.
A New Passive/Active Era
So, which is it? Active ETFs or passive funds? The answer may be both. As you can see by this chart from Hartford Funds on large-cap stocks, active and passive tend to outperform each other.
Source: Hartford Funds
Today might make the most compelling case for using both in a portfolio. That’s because today’s environment may support more flexibility when it comes to portfolio construction.
New risks have entered the chat, such as fiscal woes, rising inflation, and resetting the world’s trade order, and simply owning the broader market may not do well in all scenarios or quarters. Volatility has begun to increase.
To that end, the flexibility of active funds could provide a real serious edge to passive core strategies. There are risk controls and security selection that can be active and offer more than just a simple indexing strategy. Moreover, specific sectors of the market thrive over indexing in the first place, such as fixed income. With the ability to own securities beyond the major indexes, active bond funds could help produce additional yield and reduce many risks, such as duration and credit risk in a portfolio.
The result is that today’s atmosphere is not an either/or situation, but one that needs both active and passive ETFs to thrive.
The how-to-do-it is easy. A core and satellite portfolio could make a ton of sense. Here, investors can use passive ETFs to make up the bulk of their holdings across a diversified basket of asset classes. The following piece is where active ETFs could come in. Once you have a low-cost core portfolio in place, you can start exploring other sectors, asset classes, and styles. Systematic active indexing can also be used here.
The idea is that active management- thanks to ETFs- is now cheap enough to be worth using in a portfolio. And the current investing environment is one in which active can shine.
Popular Active ETFs
These ETFs are sorted by their YTD total returns, which range from -2.7% to 7.8%. They have expense ratios ranging from 0.12% to 0.52% and assets under management between $1.5B to $30B. They are currently yielding between 0.8% and 9.7%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| JEPQ | J.P. Morgan Nasdaq Equity Premium Income ETF | $5.58B | 7.8% | 9.7% | 0.35% | ETF | Yes |
| JQUA | JPMorgan U.S. Quality Factor ETF | $6.2B | 6.4% | 1.23% | 0.12% | ETF | Yes |
| DFUV | Dimensional US Marketwide Value ETF | $8.5B | 6.2% | 1.5% | 0.21% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $20.9B | 5.7% | 0.8% | 0.17% | ETF | Yes |
| JEPI | JPMorgan Equity Premium Income ETF | $29.2B | 4.1% | 7.4% | 0.35% | ETF | Yes |
| MINT | PIMCO Enhanced Short Maturity Active ETF | $9.7B | 2.1% | 5.3% | 0.35% | ETF | Yes |
| JPST | JPMorgan Ultra Short Income ETF | $22.8B | 1.7% | 5.2% | 0.18% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $6.7B | 0.80% | 1.4% | 0.25% | ETF | Yes |
| BINC | BlackRock Flexible Income ETF | $8.14B | 0.2% | 5.5% | 0.52% | ETF | Yes |
| DFNM | Dimensional National Municipal Bond ETF | $1.5B | -0.1% | 3.1% | 0.18% | ETF | Yes |
| MUNI | PIMCO Intermediate Municipal Bond Active ETF | $1.8B | -0.2% | 3.3% | 0.35% | ETF | Yes |
| DFAT | Dimensional U.S. Targeted Value ETF | $8.2B | -0.4% | 0.8% | 0.28% | ETF | Yes |
| FBND | Fidelity Total Bond ETF | $5.1B | -2.7% | 4.9% | 0.36% | ETF | Yes |
All in all, passive and active ETFs can be friends. Thanks to lower costs, active management can now officially play in the sandbox with indexing. And good timing, too. With the changing economic environment and dynamic market, it pays to use active management in a portfolio right alongside passive funds. Together, investors now have all the tools to increase returns and smooth out volatility as risks begin to emerge.
Bottom Line
Active? Passive? How about both? Thanks to lower costs, active ETFs are now able to hold their own with indexing. Ultimately, using them together is the best option to view during the current market environment.
1 CFA Institute Research Foundation (2024). Beyond Active And Passive Investing The Customization Of Finance
