Each of the past three years has been heralded as the “year of the active ETF” by the financial media and industry watchers (including Morningstar), Johnson notes, with so far little to show for the hype.
At the risk of looking a fool, I’m going to add my name to the list of active ETF optimists.
At least in the US, a major reason for the delay in the uptake of active (non-indexed) ETFs is that the regulator is still pondering whether to approve applications for funds that do not offer daily holdings transparency. Up to now, only active ETFs that show their holdings every day have obtained the SEC’s go-ahead.
There are plenty of rumours that the SEC is getting closer to making a decision, but we’ll have to wait and see. In Europe, the rules on holdings disclosure are less stringent, and no different for active ETFs than for any other type of retail mutual fund—that means full portfolio transparency at a minimum twice a year.
I’m a fan of transparency, but it’s not sufficient for a fund to be priced efficiently. As a retail investor, you may take some comfort from seeing the actual positions of a fund but that alone won’t help you to judge whether you’re getting good execution. For that you need a robust trading infrastructure supporting secondary market liquidity—a point made by Source’s MJ Lytle in my recent feature article on active ETFs.
But I also think the concerns about portfolio managers being “front-run” if they show holdings each day are overdone. For a start, index-tracking ETFs, most of which do show their holdings daily, are also prone to attempts by third parties to second-guess their trading moves, especially around times of index changes, and most of these funds manage to cope.
And if active managers suggest that offering daily holdings disclosure could give away their “secret sauce”, I’m a cynic. For a start, all the stats on active management show there’s a lot less sauce than advertised on the menu. Perhaps many active managers’ queasiness over disclosure is more to do with the fact that they don’t want to reveal how little they do for what they get paid. Given the continuing large inflows into index funds, active managers are not well-placed to argue this point.
But several fundamental changes mean an exchange-based distribution model for mutual funds, together with the real-time pricing of fund units, makes increasing sense.
The Old, Cosy Fund Business Is Being Dismantled
In many major markets the old mutual fund distribution model—where financial advisors were remunerated by hidden commissions to recommend particular products—has either been or is being broken down. In the UK, the regulator’s new rules for fund “platform” pricing are also now coming into effect, forcing platform operators to charge openly for their services (last week, for example, leading fund platform Hargreaves Lansdown released its new charging structure).
Gradually, I expect the funds distribution model to resemble that of shares, with fund units bought and sold via online trading sites (as is already the case for ETFs), then cleared and settled by post-trade infrastructure linked to the main trading venues. Now that fund platforms are being forced to move away from a business model that relies on commissions, you can expect consolidation in this area—and a reduction in the unnecessary and expensive overlaps between different platform providers—to happen very quickly.
Real-Time Pricing Of Funds Makes Sense
The standard mutual fund model is to price purchases and sales on the basis of a single NAV point, usually set daily. But, in the words of Stuart Thomas, a principal at Presidian Investments, a US firm that has patented a methodology for active ETFs, trading fund units daily “is an antiquated methodology that was adopted when market information was not readily available and the technology to calculate real-time portfolio prices did not exist.”
Presidian’s active ETF application, which is under review at the SEC, involves the disclosure (via third-party pricing vendors) of an active ETF’s intraday net asset value every fifteen seconds, enabling market makers to quote real-time prices for the fund in the secondary market.
In the past, trading mutual funds on the basis of a single daily pricing point (the daily NAV) has also led to market abuse, since this practice offers opportunities to arbitrageurs looking to exploit any stale prices used in the NAV calculation. Fund issuers have dealt with this by imposing penalties on those trading into or out of funds too often, or by changing to NAVs that are adjusted for fair value, but such changes merely deal with the symptoms of using a daily pricing point.
It’s surely better, though, to eliminate the source of the problem by changing the fund’s pricing methodology to a real-time one, while allowing those trading in fund units sufficient information to determine its value. This doesn’t eliminate the problem of pricing difficulties when markets from which the fund’s assets are sourced are closed. But it’s better to outsource this problem to a number of third parties acting in competition. As long as market makers have the ability to hedge, they can price a fund in real-time.
A caveat here—for a fund to be traded in real-time, its underlying assets have to be sufficiently liquid. This is no different from daily-dealing mutual funds, though, which are also susceptible to “run risk”—a recent concern of regulators.
Active ETFs Offer Cost Savings
According to Eaton Vance, which has logged its own active ETF proposal with the US regulator, exchange-traded mutual funds can offer cost savings of 50 basis points a year by comparison with traditional mutual funds, as a result of cuts in distribution, service and transfer agency fees and from reduced flow-related costs within the funds themselves.
Nick Blake, UK head of sales at Vanguard, made similar claims to this publication in September, spelling out the cost advantage of ETFs over traditional mutual funds, using two examples from his firm’s own fund range.
“The Vanguard US equity index fund costs 20 basis points a year,” said Blake. “If you buy it through a traditional UK fund supermarket, you’re going to be paying another 25 basis points or so in administration and custody charges. The adviser’s fees are on top. As an alternative, our US equity ETF costs 9 basis points a year, and a purchase via Barclays Stockbrokers, for example, costs £10.”
Blake may have underestimated fund supermarkets’ charges, though: today, Hargreaves Lansdown revealed it will be charging 0.45% a year for investment portfolios of up to £250,000 that are held on its fund platform.
Whichever way you look at it, though, the ETF/online broker route looks the much cheaper option—whether you’re buying an indexed or an active ETF.
The Way Forward
Active ETFs have so far had a slow start because of regulatory inertia, confusing terminology (we revealed last week that thousands of European mutual funds that are traded on-exchange are not even called ETFs) and, undoubtedly, as a result of fear from active managers that by offering low-cost ETF versions of their funds, they could undermine their existing pricing structures.
But none of these constraints seem serious. The prospects for active ETFs are looking steadily brighter and I expect this segment of the market to be the next big thing.