What’s Holding Back Actively Managed ETFs

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Fidelity and T. Rowe Price run some excellent actively managed mutual funds. Chances are you will never see them in ETF form.

Many new active exchange-traded funds have launched since the Securities and Exchange Commission made some important rule changes in September 2019. The total number has almost tripled from 294 to 846 today. Yet the limitations of the new rule—called Rule 6c-11—and the nature of the money-management business have prevented some of the best managers from running ETF versions of their mutual funds.

The ETF world is more competitive fee-wise than mutual funds, as it is dominated by low-cost index funds. The largest ETF,

SPDR S&P 500
(ticker: SPY), has $415 billion in assets and a 0.10% expense ratio. By comparison, the largest active stock ETF, the $15 billion

Dimensional U.S. Core Equity 2
(DFAC), is run in a quantitative style similar to index products and has a 0.19% fee, much lower than a typical active mutual fund.

In order to launch ETFs, many successful active managers will probably have to take a fee cut and risk eating into their more-profitable mutual fund business. “The ETF market is more competitive than the mutual fund market,” says Todd Rosenbluth, ETF Trends’ research head. “Asset managers need to price their ETF versions competitively. There is a legitimate fear of cannibalization.” Thus, the most popular—and profitable—mutual funds may not see ETF versions.

Fidelity launched an ETF version (FMAG) of

Fidelity Magellan
(FMAGX) in February 2021. Once one of the most famous actively managed mutual funds, it has trailed 86% of its Large Blend Morningstar fund category peers in the past 15 years. The mutual fund’s expense ratio is 0.79% versus the ETF’s 0.59%. So far, the ETF has attracted only $50 million.

ETF / Ticker	Fund Size (bil)	Morningstar Category	YTD Return	Category Rank YTD	3-Yr Return	Category Rank 3-Yr	Expense Ratio
Dimensional US Core Equity 2 / DFAC	$15.7	Large Blend	-2.2%	27	16.3%	52	0.19%
ARK Innovation / ARKK	12.9	Mid-Cap Growth	-24.5	100	17.0	39	0.75
Dimensional US Targeted Value / DFAT	7.2	Small Value	1.5	32	13.5	31	0.29
Dimensional World ex US Core Equity 2 / DFAX	4.9	Foreign Large Blend	-2.7	19	7.0	34	0.31
Dimensional US Small Cap / DFAS	4.6	Small Blend	-3.4	51	13.2	36	0.28

Note: Returns through March 28. Three-year returns are annualized.

Source: Morningstar

That would probably not be true if Fidelity launched ETF versions of its highly successful small- and mid-cap funds, such as

Fidelity Small Cap Growth
(FCPGX),

Fidelity Small Cap Value
(FCPVX), and

Fidelity Low-Priced Stock
(FLPSX), which have all crushed their category peers in the past decade. Investors would most likely flock to ETF versions of these mutual funds, but at what cost to Fidelity? Their expense ratios are 1% for the two small-cap funds and 0.65% for the mid-cap Low-Priced Stock.

Yet there are also regulatory and investment reasons preventing ETF versions of these funds. The 2019 rule changes allow active managers to run their ETFs in semitransparent portfolios that conceal some of their holdings from investors. Fidelity favors this structure to avoid copycats getting ahead of manager trades—a practice known as front-running.

But the rules for semitransparent ETFs are more restrictive. Securities that such ETFs hold must trade on public exchanges at the same time as the ETFs, which helps avoid pricing irregularities in fund portfolios. That means most foreign stocks are prohibited, as ETFs trading in the U.S. might have difficulty pricing them accurately when foreign exchanges in different time zones are closed. It also means bonds that trade largely in private “over the counter” deals are out. (Many bonds, in fact, don’t trade daily.) Some of the most illiquid U.S. small-caps, which don’t trade regularly, could also be problematic.

Currently, 37% of Fidelity Low-Priced Stock’s portfolio is in foreign stocks, so it wouldn’t be feasible in a semitransparent ETF. Fidelity Small Cap Growth and Fidelity Small Cap Value have 8% and 7% foreign exposure, respectively.

Greg Friedman, Fidelity’s head of ETF management and strategy, says asset cannibalization has been “extremely low.” Investors are choosing the ETFs not to dump the mutual fund, he says, but for their taxable accounts, as ETFs are more tax-efficient.

The firm launched the new semitransparent

Fidelity Small-Mid Cap Opportunities
ETF (FSMO) in 2021. But it has different managers from its popular small-cap mutual funds and invests more in midsize companies—57% of its portfolio. It has a 0.64% expense ratio and only $30 million in assets. “Our focus is on new strategies, and new capabilities,” Friedman says. “We are still constrained by the SEC on what we can put in a semitransparent [ETF].”

Certain mutual funds will never work as semitransparent ETFs within the current regulatory structure. The $52 billion T. Rowe Price Capital Appreciation fund (PRWCX) is one of the most beloved, having beaten 99% of its Allocation–50% to 70% Equity Morningstar category peers in the past 15 years, but it owns bonds and preferred stocks. It’s also closed to new investors—something an ETF can’t do without great difficulty.

Scott Livingston, T. Rowe Price’s head of ETF strategy, says the semitransparent structure can work with small-caps, but “there are other considerations for a large manager like us around capacity.” A solid fund, for instance, like T. Rowe Price Small-Cap Value (PRSVX)—with $13 billion in assets—already has capacity constraints. He points out that Wall Street’s market makers, which enable the trading of ETFs, can’t work with closed ETFs efficiently, as the supply of new shares is cut off, creating a trading imbalance.

American Funds and Harbor Funds offer transparent active ETFs, but neither has issued clones of their popular small-cap funds. Harbor Capital Advisors Chief Investment Officer Kristof Gleich says it’s unlikely the firm will offer

Harbor Small Cap Growth
(HISGX) or

Harbor Small Cap Value
(HISVX) “as stand-alone, fully transparent, active ETFs.” Instead, he envisions a small-cap ETF run by multiple managers so that it’s difficult to copycat anyone’s portfolio.

Yet the challenges of doing such launches remain.

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