On this week’s episode of ETF Prime, VettaFi’s Head of Research Todd Rosenbluth discusses the rise of active ETFs and anticipated ETF share class structure. Later, Fidelity’s Eric Granat and Christine Thorpe spotlight the Fidelity Hedged Equity ETF (FHEQ) and the Fidelity Total Bond ETF (FBND).

Challenges & Opportunities in Active ETFs

The ETF industry has been quickly growing, and active strategies are still punching above their weight. Forty percent of net inflows this year have gone in to active ETFs despite making up just 10% of the overall ETF asset base, Rosenbluth said.

The largest active ETFs include the $40 billion JEPI and the $33 billion DFAC. However, the most popular ETFs this year, measured by net flows, are JEPQ and JAAA, which have gathered around $7 billion and $4 billion, respectively.

Additionally, products from Capital Group and iShares, including CGDV and THRO, have been very popular this year. CGDV is a good example of stock-picking core equity ETFs in favor, Rosenbluth added.

ETF Share Class Structure Expected to See Approval Soon

The ETF share class structure is expected to be approved fairly soon. Some have suggested this could result in hundreds or thousands of new ETFs. However, Rosenbluth does not believe the industry will be overwhelmed by the supply in the initial year following approval.

“I think we’ll certainly get less than 100 new ETF share class products in the first year,” Rosenbluth said. “This is more complicated to bring to market than people might fully appreciate.”

Many firms have only a subset of products that could properly go full transparent and deal with the capacity issues, according to him.

“I also think each fund board has to have a plan for how this is going to happen,” Rosenbluth added. “We are going to see some ETF share classes within the first year, but I also think we’re going to see some firms continue to convert mutual funds to ETFs as well.”

Rosenbluth pointed to Baskin-Robbins to explain the variety of active ETFs and the importance of choice for investors. While the popular ice cream shop is well-known for offering 31 flavors, they have sold over 1,400 flavors in their history, per Gemini.

“Choice is a good thing. If you want vanilla, like the S&P 500, you want chocolate, like the Aggregate Bond Index, there are a few ETFs to consider,” he said.

“But if you want to be more creative, the flavor of the month at Baskin Robbins [is]cinnamon roll, and they had another flavor called chocolate chip cheesecake – those are for consideration,” Rosenbluth added. “It doesn’t mean people have to buy them. It doesn’t mean people will buy them. Chocolate and vanilla will still be had; they’ll still be your core equity, core fixed income strategies. But I like that we’ve got more choices in the ETF industry.”

How to Approach Due Diligence With Active ETFs

While passive managers have no control over which stocks are in an ETF, active managers can. This makes it more important to look at the track record of active ETFs, according to Rosenbluth.

“I do think that if this is an ETF share class of an existing mutual fund, or this is an ETF version of a mutual fund run by the same team, that track record is relevant to take a closer look at,” he noted.

Rosenbluth pointed to JXX, which is using the same process — active, concentrated, growth —– as a popular mutual fund previously offered by the firm.

Furthermore, active ETFs should not look like carbon copies of index funds. By looking under the hood of the holdings, an investor should be able to spot the differences in an active ETF compared to the benchmark.

How a Firm Can Differentiate Itself in a Saturated Marketplace

For a firm looking to stand out in a saturated market, education and raising awareness is of paramount importance. Rosenbluth said he is seeing firms begin to place a greater focus on education.

He discussed Fidelity’s ambitions of becoming a top three active ETF issuer. Currently, its standing is as a top six active ETF provider.

Tweedy, Browne as well as First Eagle are two other smaller firms amplifying their stories as they look to gain market share, according to Rosenbluth.

Fidelity Joins to Discuss FHEQ & FBND

Fidelity’s Eric Granat, portfolio manager, and Christine Thorpe, institutional portfolio manager, joined host Geraci to step through FHEQ and FBND.

FHEQ seeks to provide capital appreciation with reduced market volatility. There are two principal components to the fund: an equity allocation and a diversified allocation of listed and exchange-traded S&P 500 Index put options, according to Granat.

The use of cash to pay for put options and frequent rebalancing of the put allocation makes the fund unique. The rebalancing of the put allocation can be as frequent as multiple times a week. This helps maintain the strategy’s defensive positioning during periods of market downturn.

Thorpe joined to discuss FBND. The active ETF seeks to outperform the Bloomberg US Aggregate Bond Index with a similar overall interest rate risk profile.

The strategy is focused on delivering consistent, risk-adjusted returns through sector allocation and security selection. The team layers on additional exposure to things like high yield loans, leveraged loans, emerging market debt, high yield real estate, and global credit, aiming to offer additional return potential

Importance of Active Management in Options-Based & Fixed Income Strategies

Granat emphasized the importance of active management in options-based strategies, particularly in terms of entry and exit points.

“Active management gives us far greater ability to work with investors as they’re coming into the fund or leaving the fund, so that everyone gets as close to an exactly equal risk experience as a person that may have bought the fund a day a week a month earlier,” he explained.

For the fixed income space, Thorpe said she does see value in active management.

“The U.S. fixed income market is estimated to be about double the size of the Bloomberg U.S., AGG. That means an active manager has a much bigger pond to fish in,” Thorpe said. “I think if [the active manager]has really deep resources across portfolio management, trading, research, and the quant functions, I do think there is a good chance that they could potentially generate long-term returns that exceed the benchmark and potentially protect against some drawdown risk as well.”