John Hyland, CFA, is a retired ETF executive and longtime investment industry professional who has contributed articles to ETF.com.
An always popular analogy in the U.S. financial world is to describe some trend or process in terms of how many innings we are into the process.
By that standard, the emergence of the newest ETF wrapper, that of active but not fully transparent, is still in the top half of the first inning. So far, three batters—um, issuers—have come to the plate.
Although it is too early to decide how well this new wrapper will be received, we have in fact already seen things that may give us clues to how the rest of the early innings may play out.
Despite the disruptions of COVID-19, there have been six active, non-fully transparent ETFs offered this year. Two, by American Century, were listed at the end of March. One, from Legg Mason under its ClearBridge unit, started trading in May. Finally, Fidelity launched three more in June:
- American Century Focused Dynamic Growth ETF (FDG)
- American Century Focused Large Cap Value ETF (FLV)
- ClearBridge Focus Value ETF (CFCV)
- Fidelity New Millennium ETF (FMIL)
- Fidelity Blue Chip Growth ETF (FBCG)
- Fidelity Blue Chip Value ETF (FBCV)
Following are the most important early observations from the game so far.
Trading Bid/Ask Spreads
In a prior ETF.com article of mine [Read: Aussie Lessons About Nontransparent ETFs], I suggested that based on similar products trading since 2012 on the Australian Stock Exchange, that these new ETFs might trade only slightly wider than fully transparent ETFs.
For these six new ETFs, their average bid/ask spread is 21 basis points, or about 6 cents assuming a $25 NAV. These numbers are close to both the median bid/ask spread for all ETFs and to the median spread for active, but fully transparent, ETFs. Certainly these new funds are not trading at the level of a SPDR S&P 500 ETF Trust (SPY), but these are not wide spreads either.
These new ETFs are fairly lightly traded, with average daily trading measured in shares of 26,000, or about $650,000. These numbers are small compared with the massive trading of established ETFs, and particularly of index-based ETFs.
On the other hand, they are in line with the daily trading of the almost 40 active, but fully transparent, ETFs launched so far in 2020. The reality is that active equity ETFs generally do not have massive trading levels, regardless of their disclosure regime or asset base.
There was speculation when the new wrapper was approved as to how the issuers of these new ETFs would price them in terms of total expense ratios. The most interesting comparison would not be how expensive they are compared to passive ETFs or active, but fully disclosed, ETFs, but how inexpensive the new ETFs are compared with the same or similar strategy offered by the same issuer in the more traditional active open-ended mutual fund format.
The total expense ratios of the six new entries ranged from 42 basis points to 59 basis points. Those are fairly high compared to the traditional ETF expense ratios. However the mutual funds that are offered by the new ETFs issuers that are most similar to the new funds have expense ratios ranging from 60 basis points to 98 basis points.
The difference between the new ETFs and the existing mutual funds in terms of expenses has the ETF versions priced from 6 basis points to 56 basis points lower with an average savings to investors of 24 basis points.
A mutual fund look-a-like product, but with 24 basis points lower annual expenses, is not a trivial benefit. Issuers using the new ETF style can make those savings in part because their shareholder servicing costs would be much lower for an ETF. But they may also be pricing in another factor: lower distribution payments made to third parties—which leads us to our next observation.
Distribution Payments To Third Parties
Many mutual fund firms find themselves paying brokerage firms to allow the sale of their mutual fund on the broker’s platform. These fees, sometimes but not always taken in the form of a 12b-1 fee, often run 25 basis points or more.
By comparison, most ETFs do not pay distribution fees to the Merrill Lynch, Morgan Stanley or Schwabs of the world. In some cases, such as Charles Schwab’s “ETF One Source,” firms have paid to be on its ETF platform, but the amount paid was typically more like 6 basis points.
It is too early to know exactly how this facet will be resolved, but some industry observers think that the brokerage platforms know they will have to end up getting far less than 25 basis points in any form of distribution payment or revenue sharing. Figures being discussed are in the under 10 basis point range.
Even then, the brokerage firms know that some major ETF issuers will still refuse to pay anything, and will essentially dare the platforms to try and block RIAs and investors from accessing their new ETFs.
Four of the six new ETFs have so far failed to gain much traction in raising assets. However, those four are also the newest ones issued. The first two, American Century’s FLV and FDG, have raised almost $200 million since the end of March.
It appears that most of the money in FLV and FDG was sourced from within American Century as opposed to new, outside money. In essence, they are succeeding with a BYOA approach (“bring your own assets”).
This is in fact how many newer ETFs and ETF issuers have gained scale in recent years, and comes as no surprise. In fact, what might be a bigger surprise would be if, in the early stages, most of the money did come from the outside.
No idea when the later issuers, Legg Mason and Fidelity, will start to see major flows into their ETFs. However, it is widely assumed within the ETF industry that BYOA is part of their roll-out plan.
Next Set Of Batters
In addition to the three existing issuers of these new style ETFs, up to seven new issuers may be offering products before year end. The potential new issuers include major names such as BlackRock, J.P. Morgan and T. Rowe Price.
Both the number of potential new players, and the size of many of them, suggests that we will likely see a lot more of these new ETFs come to the plate between now and December 2020.
A Wild Card In The Race
Several months ago, ETF.com ran another piece of mine discussing the possibility that mutual fund issuers could convert a mutual fund into an ETF [Read: “How Mutual Funds Convert To ETFs”]. Recently a small U.S. mutual fund and ETF issuer, Guinness Atkinson, filed with the SEC to convert one of its existing mutual funds into an ETF.
The intended ETF is not expected to be an active, non-fully transparent ETF, but it may still blaze a path forward for any mutual fund company to decide to convert an active, non-fully transparent mutual fund into an active, non-fully transparent ETF.
If such a mutual-fund-to-ETF could be offered with a reasonable bid/ask spread and 20+ basis points in a lower annual expense ratio, the appeal to do so may prove irresistible. Not so much because the fund manager will automatically assume that the new wrapper will make it easier to raise new assets; rather, because using the new wrapper may help protect the fund manager from losing existing assets to ETFs and other products. In baseball terminology, this is a defensive switch, not an offensive switch.
The new product approach is doing well in this early inning if you just look at bid/ask spreads or the expense savings when compared to the mutual funds from which these ETFs tend to spring.
Questions remain, however, as to the ability of the new funds to either raise new assets or allow a fund manager to convert existing in-house assets to the new wrapper. For the answer to those questions, we need to see some more batters and play a few more innings.
You can reach John Hyland at [email protected].