Why the regional bank crisis could help fuel a shift to active ETFs

The failures of three regional banks since March have brought down other stocks in the sector, even if the remaining banks insist their business is strong, and created an opportunity for active fund managers to pitch their skills to investors. Even as a better-than-expected first-quarter earnings season has supported the wider stock market, funds with high exposure to regional banks have been punished. The Vanguard Small-Cap Index ETF (VB) is down 10% over the past three months, and the SPDR S & P Regional Banking ETF (KRE) has plunged 40%. VB 3M mountain Passive small-cap funds like VB have been hurt by the regional banking crisis. Those steep declines may in part be due to the passive nature of those funds. "Of the 130+ passively managed small-cap ETFs, the average Financials sector exposure is 16%. By our work, that's a been a significant hindrance to small-cap returns and recently magnified by Regional Bank issues" Strategas ETF strategist Todd Sohn said in a note to clients. Active funds are still a relatively small fraction of the the ETF market, but they have been gaining ground this year. While overall flows to equity funds have been tepid in 2023, active equity funds have seen 41 consecutive months of inflows, according to State Street's SPDR ETF division. Small-cap funds is one category where active funds should have plenty of room to grow, Sohn said. "With market-cap weight ETFs dominating the space at 91% of AUM and 59% of passive product count, we tend to wonder if the future of the small-cap ETF universe is via actively managed funds. There's only 24 products, although AUM has jumped from under $3 billion three years ago to over $20 billion today ... in an industry where some segments are saturated, this seems like an area of opportunity," Sohn said Of course, the active component can be a double-edged sword, since a manager could be overweight a sector that sees a sudden decline. Research shows that very few active managers can consistently beat index funds, and the index funds are almost always cheaper for investors by expense ratio. One type of active fund that is gaining traction is broad, low-cost funds that have low turnover but retain more flexibility than pure index funds. For example, the Dimensional US Core Equity 2 ETF (DFAC) -- which has more than 2,700 holdings and measures itself against the Russell 3000 -- has pulled in nearly $1.7 billion in inflows this year. That is third most among total market U.S. equity funds this year, according to FactSet. Volatile and news-filled periods like last week make the argument for that type of approach, said Nicole Hunter, head of ETF capital markets at Dimensional. "It's where you want to be -- the whole broad diversity of a portfolio where no single name is going to disproportionately affect you like it would in a very active fund that has a larger weight," Hunter said. DFAC, with an expense ratio of 0.17%, is down less than 4% over the past three months but has underperformed the Russell 3000. Another consideration for investors is that switching to an active fund now could mean missing a rebound. Research from EPFR suggests that times when ETFs are declining in price but seeing strong inflows -- which would apply to the KRE in recent weeks -- can be a buy signal. The inflows could be a sign of investors seeing value or a sign of high levels of short interest, as shorting ETFs can involve creating new shares of the funds to then sell. The KRE jumped more than 6% on Friday, trimming its recent loss, as some of the most beaten-down stocks such as PacWest rebounded sharply .