For years, really smart people have been trying to figure out how to shoehorn active management strategies into the ETF wrapper. Fidelity is the latest to try, and as explained by my good friend Dave Nadig, its new proposed design is clever.
The problem firms like Fidelity are trying to solve is that current Securities and Exchange Commission rules require actively managed ETFs to disclose their full portfolios on a daily basis.
Particularly in the equity space, active managers do not want to do that, because they fear that hedge funds and prop traders will use that information to front-run their trades.
The Fidelity proposal takes the clever approach of creating what amounts to a closed-end fund (CEF) and ETF hybrid. New products would be structured as closed-end funds, which allow for more limited disclosure, but would have weekly creation/redemption activity that could help solve the big problem with CEFs—their tendency to trade at large premiums and discounts.
Pricing Nut Tough To Crack
Like most proposals for quasi-transparent and nontransparent active ETFs, I’m pretty sure the Fidelity approach will work. For all of the structures I’ve dug into, it strikes me that the benefits that accrue to using an ETF structure instead of a mutual fund structure far outweigh the risks created by any aspect of nontransparency.
For those who don’t know, the big concern with nontransparent ETFs is that the market may not know how to price them perfectly; as a result, officials worry they could trade at unknowable premiums and discounts to their net asset values. That’s probably true to some extent, and despite clever efforts like Fidelity’s to mitigate the problem, I’d be surprised if nontransparent ETFs didn’t trade a few pennies wider than transparent funds.
However, the benefits that offset that are significant: lower costs, greater tax efficiency, more trading flexibility and a fairer allocation of entry and exit costs compared to traditional mutual funds.
To me, it’s not even close. If mutual funds didn’t exist today and someone were trying to launch one, they’d be laughed out of the room. Imagine the SEC considering a structure that allowed shareholders who continue to hold a fund to pay the trading costs for people who are selling out of a fund. It’s absurd on the face of it. Eventually, I think the SEC will see that the balance of good favors nontransparent ETFs.
New Wrapper Won’t Change Active’s Issue
All that said, I worry for those who think putting traditional active funds into an ETF wrapper will be the silver bullet that saves active management. After all, active equity funds lost $89 billion in assets in 2015, and have been consistently bleeding assets since at least the 2008 financial crisis.
But simply putting the same old active strategies into a slightly more efficient, slightly more accessible wrapper will not solve this problem. The forces that drove $389 billion in net new money into passive strategies in 2015 while $89 billion fled active strategies are not the fact that ETFs are (maybe) 5-10 basis points cheaper to run than mutual funds or that they save on custodial and transaction fees.
The problem is that active managers can’t seem to outperform the market consistently, and index strategies are constantly creating ways to mimic the best parts of active management at ever-lower costs.
In a world where 80%+ of active managers underperform their benchmarks over 10 years—and you can buy exposure to Goldman Sachs’ quant-active strategies with a fee of 0.09% a year in its ActiveBeta ETF, GSLC—no amount of efficiency or convenience is going to convince investors to pony up.
2 Possible Solutions
What active management needs, much more than an efficient wrapper, is some guts. When pure beta is free and multifactor quantitative exposure from one of the world’s leading banks costs 0.09% a year, there are really only two places left to turn:
- High-conviction, high-concentration portfolios that seek extremely high “active share” and offer truly differentiated exposure to the market.
- Asset-allocation-style strategies that use other ETFs to overweight particular sectors, strategies and factors in the market.
We’re already seeing various approaches to the second format, whether in the guise of robo advisors, the rise of ETF strategists or the impressive growth of packaged ETF solutions like the First Trust Dorsey Wright Focus 5 ETF (FV).
The latter relies on Dorsey Wright’s momentum model to rotate among 25 different U.S. sector and niche ETFs from First Trust. It has gathered $3.2 billion while charging a healthy management fee of 0.89%. Active in all but name, it should be a symbol to active managers about what truly transparent strategies can do.
As for high-conviction strategies, none have yet gained a significant following in ETF-land, but I’d love to see someone try. I’m not convinced high-conviction funds would actually be good for investors—the academic literature on high active share strategies is mixed (this article says they’re great, this one isn’t so sure). But at least they would offer investors something they can’t get in a low-cost indexed package.
That—and not the question of transparency—should be the focus of active managers right now.
At the time of writing, the author did not own the ETF mentioned. Matt Hougan is CEO of InsideETFs and can be reached at [email protected].