The Outlook for Active ETFs

February 01, 2013

 

Stephen Clarke
Stephen Clarke
President
Navigate Fund Solutions LLC
Eaton Vance

What will it take to make active ETFs commercially successful (beyond BOND and MINT)? Do you think there will ever be significant growth in the space? What is the biggest impediment to that?
Although a handful of active, fixed-income ETFs have been commercially successful, no active-equity ETFs have to date achieved significant success. The requirement for active ETFs to disclose their full holdings on a daily basis is incompatible with most managers' belief that revealing current fund trading information can be both harmful to fund shareholders and against the business interests of fund sponsors. For active ETFs to achieve broad success, a new trading protocol for active ETFs needs to be adopted that can assure a tight relationship between market trading price and NAV without full current fund holdings disclosure.

How do you think advisors will incorporate active ETFs into their portfolios? Will the funds compete with other passive ETFs or with active equity mutual funds?
Active ETFs seek to provide the performance and tax-efficiency advantages of the ETF structure to investors in active strategies. They compete against passive ETFs based on the potential to add value through active management. They compete against active mutual funds based on the potential of the ETF structure to lower costs and improve investor returns. What we call "exchange-traded managed funds" or "ETMFs" seek to provide active fund investors with access to the cost and tax efficiencies of the ETF structure without requiring full daily holdings disclosure, using NAV-based trading. We see ETMFs as having the potential to transform the delivery of active strategies to fund investors across a broad range of investment types.

Will the SEC ever allow nontransparent actively managed ETFs?
To gain approval, any proposal for nontransparent, actively managed ETFs will have to demonstrate to the SEC's satisfaction that it contains a reliable mechanism to ensure that the fund will trade in the secondary market at narrow premiums and discounts to NAV. We believe that our ETMF proposal incorporating NAV-based trading can meet that test.


 

Mebane Faber
Mebane Faber
Chief Investment Officer
& Portfolio Manager
Cambria Investment Management

What will it take to make active ETFs commercially successful (beyond BOND and MINT)? Do you think there will ever be significant growth in the space? What is the biggest impediment to that?
There already has been significant growth, and we think we are in the early innings of a big shift in assets from mutual funds to ETFs, both active and passive.

This is a bit of a tricky question for me since I'm a quant and I believe that every strategy is active, as you have rules for buying, selling and rebalancing. However, many don't understand that one of the biggest costs for these index funds that disclose their methodology is that there exist traders that front-run index rebalancings. This is a very real cost to the indexes that does not show up in their returns. Academic studies have estimated it costs upwards of a few percentage points for the less liquid markets.

However, most of the successes in active ETFs so far have been in the fixed-income space. That is the opposite of the active space for mutual funds, which is dominated by active equity funds. Once investors understand that the tax benefits of the ETF structure is especially important for the more active equity funds, the tide will become a flood of assets moving from active, high-fee mutual funds to lower-cost, tax-efficient ETFs.

How do you think advisors will incorporate active ETFs into their portfolios? Will the funds compete with other passive ETFs or with active equity mutual funds?
Both, as it depends on the fund and the mandate. Some active ETFs will replace traditional-core, active-mutual-fund holdings, while others will serve more of an alternative role to diversify a traditional beta exposure. In both cases, active mutual funds will be the loser. They simply can't compete on cost or tax efficiency.

Will the SEC ever allow nontransparent actively managed ETFs?
Frankly, I hope they don't! Many fund companies fear transparency because they charge way too much for way too little (if any) alpha.

 


 

Noah Hammon
Noah Hammon
Founder & CEO
AdvisorShares Investments

What will it take to make active ETFs commercially successful (beyond BOND and MINT)? Do you think there will ever be significant growth in the space? What is the biggest impediment to that?
The biggest impediment is time. I don't recall any time in history when investors heard about a new active strategy and immediately rushed to invest funds in the new strategy. The active ETF structure is more innovative than the traditional mutual fund structure. When a proven firm such as Pimco launches a proven strategy such as total return, then, as we have seen with the results, it can lead to asset growth success. With that said, in the first four years of actively managed ETFs, there are more active ETFs and more active ETF assets than index ETFs had in their first four years. We see that as a successful launch, but believe over time that the best is yet to come.

How do you think advisors will incorporate active ETFs into their portfolios? Will the funds compete with other passive ETFs or with active equity mutual funds?
Advisors will use active ETFs similarly to how they would use a no-load mutual fund—usually as part of an overall asset allocation strategy. Initially, I believe the assets are coming from traditional mutual funds and advisors who are comfortable with an actively managed strategy, but also interested in adding the benefits of the active ETF structure to their clients' portfolio. Think about these types of advisors, who finally for the first time with an active strategy, can implement better risk management tools by using limit orders or stop loss orders. Over time, if the active ETF managers are able to demonstrate value for the fee they are charging, then I do believe the beta-basket investors will consider adding in some alpha baskets to their process.

Will the SEC ever allow non-transparent actively managed ETFs?
You should never say never, but I don't see it happening anytime soon, if ever. It seems to be moving in the opposite direction in terms of the regulatory direction and investor demand. Everyone wants more transparency. As I understand the non-transparent model, a few participants know the actual underlying holdings that represent the value of the ETF. Everyone else gets a "modified replication" basket, with the understanding that they have to "trust" the computer model used to create this modified basket closely tracking the value. I believe investors are less trusting of this approach and market makers would likely have wider spreads to adjust for this risk. In addition, as we continue to see an increase in the number of insider trading cases, I don't see the SEC having much of an appetite to provide exemption for a limited disclosure product.


 

Daniel Mccabe
Daniel McCabe
Chief Executive
Precidian Investments

What will it take to make active ETFs commercially successful (beyond BOND and MINT)? Do you think there will ever be significant growth in the space? What is the biggest impediment to that?
It will take a well-known, established brand to enter the market and bring product in a more efficient form than what they are offering today in the mutual fund arena. I don't doubt that this will become a very successful area and an attractive space for asset managers to be in. But all of this takes time.

The biggest impediment to growth right now is the SEC. Firms such as BlackRock have had filings for four-plus years, and I think that you're going to see other firms that are going to be looking to offer what are really "next-generation" mutual funds to clientele. It's all about efficiencies: If I can offer a product that's more tax efficient for the investor and more efficient for the fund manager to manage, and it allows the investor access to the money in real time, why wouldn't I want to be able to do so? I think that we're going to get there and that it's a matter of adoption.

How do you think advisors will incorporate active ETFs into their portfolios? Will the funds compete with other passive ETFs or with active equity mutual funds?
Actively managed ETFs are going to compete with both. People are looking for performance, and the majority of people are looking for alpha. If I can have a product that can outperform the benchmark, I'd rather be long that product.

Most advisors have platforms; ETFs are building blocks inside a platform. [The growth of actively managed ETFs] is going to make people look at performance in a way that maybe they haven't before. I'm going to be able to compare the performance of different funds directly. I'll be able to pull it up on a website and say, "This is what Manager A did in comparison to Manager B." That's going to make people accountable, and that will be a very positive thing for investors. We'll see weaker managers struggle a little bit, and stronger managers will probably gain assets. It will give an RIA the ability to look at funds in real time and maybe make more accurate decisions for his client. It won't be all about 12b-1 fees.

I think this will keep people honest. We all talk about the need for transparency. If everything's out there and open, I can value the portfolio intraday and look at the valuation of that portfolio in real time versus another asset manager's performance. I can make better decisions, and I can be a little bit more tactical.

Will the SEC ever allow nontransparent actively managed ETFs?
They would have to. It's a natural evolution. I believe the SEC is supposed to be a disclosure regulator; I don't think they're supposed to be choosing products based on what they perceive the merit of the product to be. There are some very large active managers that are very interested in bringing specifically equity-based products to market, and they are not willing to show all their competitors the underlying holdings


 

Shawn McNinch
Shawn McNinch
Global Head of ETF Services
Brown Brothers Harriman

What will it take to make active ETFs commercially successful (beyond BOND and MINT)? Do you think there will ever be significant g