The Rise Of Active ETFs

In a turbulent market, new options for yields, diversification and downside protection

by Matt Barry

Actively managed ETFs garnered $46 billion in net inflows in the first half of 2023, representing 22% of total ETF flows. Since 2018, Active ETFs have grown from two percent to six percent of all US ETF assets – and are poised for continued growth after a flurry of product development as active asset managers have piled into the ETF market in recent years.

Why have actively managed ETFs demonstrated such growth in recent years? One primary reason is the ETF Rule (Rule 6c-11), which the SEC adopted in 2019 to modernize the regulation of ETFs. This was an important development as it enabled asset managers to bring ETFs to market faster and with less cost than previously required. It also leveled the playing field by allowing active ETFs to take advantage of trading processes that had historically been used within passive ETFs to help realize the tax efficiency benefits attributed to the ETF vehicle.

The second reason is pent-up demand. There are over $12 trillion of assets in actively managed long-term mutual funds. Active ETFs can attribute their growing popularity to their combination of active management’s potential for outperformance with the structural benefits of the ETF vehicle such as tax-efficiency, liquidity, and transparency. While the ETF market is mature, the active ETF market (particularly for equity strategies) is in its infancy. The greatest demand will come from financial professionals who have traditionally utilized open-end mutual funds to construct portfolios – not from the customary investors in ETFs which have been, until recently, heavily slanted toward indexing.

Many investors appreciate the appeal of active management, in particular its ability to provide potential for above average returns and beat the benchmark. In a continuously volatile market environment, investors are increasingly seeking ways to increase cash flow, generate yield and diversification, and protect portfolios. Now more than ever, active ETFs are an attractive vehicle for both investors looking to meet those goals, and financial advisors offering insights and portfolio management advice.

Distinctively Active

At Touchstone Investments, we have leveraged the powerful combination of active management and the ETF vehicle over the last year to meet the continuously growing demand for active ETFs. To that end, Touchstone launched four actively managed ETFs across a wide range of sectors in the summer of 2022. Over the first year, no Touchstone ETF realized capital gains distributions – demonstrating the tax-efficiency of the ETF vehicle – while all four performed according to their objectives– demonstrating the potential benefits of active management.

Touchstone ETFs, like Touchstone mutual funds, are “Distinctively Active”. Distinctively Active strategies represent a subset of the active (i.e., non-indexed) strategy universe. They provide investors with access to institutional asset managers who manage the strategies while demonstrating high conviction and highly active management that is different from the benchmark, in our opinion. Being different from the benchmark is a prerequisite to outperforming the benchmark, and our approach is based on academic research that builds on that concept. Our own research indicates that a high proportion of the active management universe has characteristics that substantially diminish the potential for outperformance. That’s why we focus on the subset of distinctively active strategies, designed to best position investors for the benefits of active management.

In addition to Touchstone’s first four ETFs Dividend Select (DVND), US Large Cap Focused (LCF), Strategic Income Opportunities (SIO) and Ultra Short Income (TUSI) two additional active ETFs have launched in 2023 – the Touchstone Climate Transition ETF (HEAT) and the Touchstone Securitized Income ETF (TSEC). HEAT will invest in companies whose growth should benefit from regulations, innovations, services, or products related to the global fight against or adaptation to climate change. Climate transition is one of the most visible and enduring themes of the 21st century, with trillions of dollars being invested globally in the fight against climate change. HEAT’s sub-adviser, Lombard Odier Investment managers, takes an active approach, scouring the globe to find 40-50 stocks they believe are positioned to benefit from the transitioning climate environment.

TSEC, which launched in July 2023, takes an active approach by focusing on fixed income investments including asset-backed securities, mortgage backed securities, and collateralized loan obligations. Securitized products have historically offered an attractive risk/return profile relative to other fixed income asset classes. TSEC is unique because of its portfolio management team and their extensive experience managing securitized fixed income assets. The team at Fort Washington Investment Advisors managing the strategy has over 20 years average experience. We believe they have strong front-end due diligence and back-end surveillance processes to navigate markets and manage risk and have deployed those capabilities in the underlying strategy for over a decade with strong results. We think the portfolio is well-positioned for today’s environment with a relatively low duration and attractive yield-to-worst approaching double digits.

With these recent launches, Touchstone contributes to a growing wave of issuers and new products in actively managed ETFs, a space we anticipate will continue gaining traction moving forward.

A Look Ahead for Active ETFs

We believe several trends are on the horizon for active ETFs. First, we expect continued growth in the number of products as well as assets in active ETF strategies. Many issuers have entered the market in the past few years and we expect the assets to accelerate as those ETFs achieve the track record thresholds that many financial advisory firms require as a prerequisite for ETFs to be made available. We expect that issuers that have already launched actively managed domestic equity and fixed income ETFs will expand their product rosters by launching additional products in areas like international fixed income and equity ETFs, thematic ETFs and buffered ETFs that limit downside participation.

Second, we anticipate a continued acceleration of mutual fund-to-ETF conversions. Touchstone is planning its first mutual fund to ETF conversion this fall. We are excited to offer shareholders the benefits of the ETF vehicle, including a lower total expense ratio and increased tax efficiency, through the reorganization of the Touchstone Dynamic Allocation Fund into the Touchstone Dynamic International ETF. We expect many other active issuers to continue the trend of mutual fund to ETF conversions as they seek to deliver the benefits of the ETF vehicle to their mutual fund shareholders. Of course, there are many scenarios where a conversion may not make sense – if the fund has significant retirement plan assets or is capacity constrained, for example. Issuers should take a case-by-case approach when evaluating potential conversions. We also appreciate the concept of ETF conversions remains fairly novel so it is important that we provide significant lead time to the firms and investors that utilize our strategies so they can prepare effectively.

Finally, it is worth monitoring the SEC’s response to recent applications from ETF issuers to launch an ETF as a share class of an existing mutual fund. For years, Vanguard has offered ETF-as-share class within an open-end mutual fund rather than as a separate vehicle. Vanguard’s patent on the structure expired after twenty years in May 2023, potentially creating a path for other ETF issuers to offer new ETF share classes embedded within existing mutual funds. Why is this important? The ETF-as-share-class model would allow issuers to create and launch ETFs from existing mutual funds. The ETFs would likely benefit from the scale of the existing mutual fund as well as the performance record. However, it is unclear whether the SEC will approve requests for exemptive relief from the issuers that have applied. Further, the Vanguard order only applied to index ETFs, so there is even more uncertainty whether the SEC would extend the relief to active managers. Still, the benefits of the ETF-as-share class model could be significant for shareholders so we expect many other issuers to follow if and when the SEC grants exemptive relief.

The rise in actively managed ETFs has been sharp in recent years since the ETF Rule was adopted. We expect the trend to continue as asset managers seek to offer investors the benefits of active management with the advantages of the ETF vehicle. New product development – including expanded ETF offerings in new investment spaces, conversions of funds to ETFs and, perhaps, ETFs as share classes of funds – will provide investors with greater choice. Expanded choice will be supplemented by many of the recently launched active ETF strategies achieving minimum track record criteria required by many investors and financial professionals. Together, in fact, we expect these factors will significantly accelerate the growth of active ETFs. As investors and financial professionals transition from open-end mutual funds toward the lower cost and more tax efficient ETF structure, Touchstone is positioned to help drive continued growth in the active ETF space.

For performance information current to the most recent month end visit www.westernsouthern.com/touchstone/etfs

Touchstone ETFs are distributed by Foreside Fund Services LLC
a registered broker-dealer and member of FINRA.
Investing involves risk, principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. Shares are bought and sold at market price not net asset value. Market price returns are based upon the consolidated market price and do not represent the returns you would receive if you traded shares at other times.

Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 833-368-7383. Please read the prospectus and/or summary prospectus carefully before investing.
Yield-to-Worst is the expected yield assuming the earliest allowable retirement date.

Touchstone exchange-traded funds (ETFs) are actively managed and do not seek to replicate a specific index. ETFs are bought and sold through an exchange at the then current market price, not net asset value (NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV when traded on an exchange. Brokerage commissions will reduce returns. There can be no guarantee that an active market for ETFs will develop or be maintained, or that the ETF’s listing will continue or remain unchanged.

The Adviser engages a sub-adviser to make investment decisions for the Fund’s portfolio; it may be unable to identify and retain a sub-adviser who achieves superior investment returns relative to other similar sub-advisers. Events in the U.S. and global financial markets, including actions taken to stimulate or stabilize economic growth may at times result in unusually high market volatility, which could negatively impact Fund performance and cause it to experience illiquidity, shareholder redemptions, or other potentially adverse effects. Financial institutions could suffer losses if interest rates rise or economic conditions deteriorate. The Funds’ service providers are susceptible to cyber security risks that could result in losses to a Fund and its shareholders. Cyber security incidents could affect issuers in which a Fund invests, thereby causing the Fund’s investments to lose value.

The Fund’s climate transition investment criteria may limit the available investments or may cause the Fund to forgo opportunities to buy certain securities, or forgo opportunities to gain exposure to certain industries, sectors, regions and countries, which may cause the Fund to underperform funds that invest in a broader array of investments. In addition, the Fund may be required to sell a security when it might otherwise be disadvantageous for it to do so.

The Fund invests in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. The Fund invests in mortgage-backed securities and asset-backed securities which are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. The Fund invests in investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. The Fund invests in non-investment grade debt securities which are considered speculative with respect to the issuers’ ability to make timely payments of interest and principal, may lack liquidity and has had more frequent and larger price changes than other debt securities. The Fund invests in U.S. government securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates.