Even before the first active dual share class fund from Dimensional launched, active mutual funds and ETFs were already roommates rather than existing in separate silos. Ben Johnson, head of client solutions at Morningstar, revealed in a LinkedIn post that active managers are increasingly using ETFs as essential tools for building portfolios.
“These funds’ managers are drawn by the same features that have led millions of other investors to ETFs over the past 33 years: low costs, liquidity, tax efficiency, and transparency,” Johnson told TMX VettaFi. He further noted that as of the end of last year there were almost 1,200 active mutual funds that owned at least one ETF.
Key Takeaways:
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Since 2006, the number of active mutual funds holding at least one ETF has more than doubled. The average weight of those positions has also increased fivefold, signaling that ETFs have evolved from competitors into essential building blocks for active managers.
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Active mutual fund managers utilize ETFs as an “easy button” to maintain market exposure through cash equitization, bridge allocation gaps, and gain instant, liquid access to niche or hard-to-trade global markets like emerging market equities.
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The usage of ETFs ranges from total portfolio construction — such as target-date funds that exclusively hold ETFs to provide low-cost solutions for 401(k) plans — to surgical, fractional positions used for precise liquidity management.
See more: Dimensional Widens Bridge Between ETFs & Mutual Funds
Double the Ownership
With the ETF market seeing parabolic growth and rapid adoption over the years, its integration into active mutual fund portfolios is no longer a niche tactic. Based on the data shared by Johnson, the number of active mutual funds holding at least one ETF has more than doubled since 2006.
Furthermore, the average weight of ETF positions within these active mutual fund portfolios has increased fivefold within that same timeframe. Johnson’s data suggests that for modern managers, ETFs are a structural necessity. They provide tactical exposure that individual stocks often cannot do.
It was well-documented last year that the number of ETFs outpaced individual stocks. This gives portfolio managers increased optionality on how best to use ETFs as tactical tools that can achieve portfolio performance goals and add liquidity. For example, ETFs can be used as cash equitization vehicles. Rather than staying in cash, active mutual fund managers can park excess capital into ETFs for broad-market exposure, thereby mitigating the concentration risk of holding individual stocks. They can maintain this market exposure to ETFs while searching for stock-specific opportunities, which prevents cash drag.
Diversified Exposure
Additionally, the growth of ETFs has democratized access to niche corners of the global market. ETFs provide exposure to hard-to-trade or less liquid markets that were once the playground of only institutional investors and global investment firms. This includes emerging market equities or niche sectors where direct security ownership may be limited for retail investors. By integrating ETFs into their portfolio strategies, active managers can bridge allocation gaps and hedge risk. For example, they can park cash in low-volatility ETFs during wild market swings and temporarily allocate capital while searching for high-conviction alpha generation.
“ETFs are an ‘easy button’ for fund managers looking to equitize cash or tap in to niche corners of global markets,” Johnson said.
See more: Aberdeen Converts Mutual Funds to 2 New Active ETFs
Active Mutual Fund Examples
Johnson cited ownership cases by active mutual funds from the most extreme to the least. On one hand, there’s the Schwab Target Index Fund series that owns ETFs exclusively. Moreover, these target-date mutual funds are the epitome of keeping things in-house. They are constructed entirely of Schwab’s own ETFs, ranging from small-cap equities through the Schwab U.S. Small-Cap ETF (SCHA) to broad-market bonds via the Schwab U.S. Aggregate Bond ETF (SCHZ). In this specific use case, the mutual fund is the primary structural wrapper. It allows the tax efficiency and lower costs of ETFs to flow through traditional 401(k) plans that may not yet support direct ETF trading. As Johnson noted, this model allows for a sophisticated, low-cost Qualified Default Investment Alternative (QDIA) that’s conducive to smaller retirement plans.
On the opposite end of the spectrum, managers can use ETFs for fractional, but precision-based exposure. Johnson cited the GMO Opportunistic Income Fund (GMOLX), which held a minimal 0.02% stake in the GMO Ultra-Short Income ETF (GMOC) at the end of last year.
In either case, whether it’s the primary driver of a fund’s portfolio or just a minor component, ETFs now appear in nearly 1,200 active mutual fund portfolios. This proves that the ETF wrapper is a viable fixture in institutional asset management.
Blurred Lines
The trend of active mutual funds buying ETFs highlights the blurring lines between the two fund structures. By using ETFs, active mutual fund managers prove that they aren’t perfect strangers, but peers that can coexist in the capital markets.
The data from Morningstar is clear: active mutual fund managers aren’t fighting the ETF revolution, but buying into it — literally.
Originally published on ETF Trends
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