Vanguard: Why Active Management Has A Future

July 16, 2018

[This ETF Industry Perspective is sponsored by Vanguard.]

Active management will survive, and maybe thrive, if it’s available at a low cost. ETFs, then, offer an attractive vehicle.

Active management is not new for Vanguard. We have believed in low-cost, long-term active strategies since our founding more than four decades ago. In fact, Vanguard Wellington FundTM started in 1929, and today Vanguard has more than 60 traditional active funds.

With the recent launch of our first active ETFs—a suite of low-cost factor-based funds—we wanted to share some thoughts regarding the past, the present, and the future of active management in the context of ETFs as you seek to find the best ways to help your clients meet their goals.

In short, we believe active management strategies1 do have a future, though we also believe that the relatively expensive active strategies of the past are likely to fall increasingly out of favor.


First, a little history …

As ETFs celebrate their 25th anniversary this year, there’s little doubt that ETFs are still widely associated with index investing. But did you know that U.S.-listed active ETFs have been around for more than a decade?

Since active ETFs became part of the ETF ecosystem, many firms and commentators have predicted that actively managed ETFs would likely fuel ETF development. Dozens of firms have filed with the Securities and Exchange Commission (SEC) to offer active ETFs in the hope of taking advantage of this potential opportunity. As of February 28, 2018, the active ETF marketplace consisted of 208 ETFs offered by more than 60 issuers.


Active fixed income ETFs leading the way

Ten years into the age of active ETFs, it’s fair to say that investors have yet to adopt these investment vehicles the way they did their index-based counterparts. As of March 20, 2018, U.S.-listed ETF assets stood at about $3.6 trillion, with 2017 inflows shattering previous cash-flow records. Yet active ETFs languished in this extremely favorable environment of ETF adoption.

Since 2008, 271 active ETFs were launched, though 63 were shuttered, leaving the 208 cited above. That compares with about 1,700 index ETFs listed on U.S. exchanges today.

1 Vanguard considers any deviation from broad-market, capitalization-weighted indexing to be active management—even non-cap-weighted strategies in rules-based indexes. But this article is solely focused on traditional active management that involves human portfolio managers making changes based on quantitative models or other tools.


Active ETF launches

Source: Vanguard, as of February 28, 2018.

The number of active ETFs accounted for only 11% of all ETFs on U.S. markets; assets in these strategies reached $40.6 billion, or less than 1.2% of all U.S.-listed ETF assets.2 Drilling into that relatively low figure, fixed income strategies dominated the active ETF space, gathering 75% of active ETF assets under management, Morningstar data show.

Despite the available runway for active ETFs, issuers still hesitate. At this time, the SEC requires firms to provide full transparency into ETFs’ daily holdings. Some issuers are concerned that this disclosure will prove harmful because it reveals proprietary alpha-generation techniques.

As a result, many active issuers have petitioned the SEC to allow “nontransparent ETFs,” but these requests have yet to materialize, except for one instance. The one instance, a new structure, is an exchange-traded managed fund and it is not technically an ETF. Rather, it is a hybrid structure that has features of both ETFs and traditional mutual funds. So far, 15 products have launched in this structure, with collective assets of about $135 million, according to Morningstar.

Other ETF firms have become more comfortable with full transparency of active ETFs that follow certain strategies. Since the start of 2017, 24 issuers have offered an active ETF for the first time. For Vanguard, we have launched only actively managed strategies that can accommodate daily holdings disclosure. These generally include high-capacity, model driven strategies with trading flexibility.


Our view of the future

The current active ETFs may lead the way forward as due diligence teams at home offices begin incorporating active ETF evaluation into their oversight processes. As more active ETFs are placed on trading platforms, advisors may gravitate toward the potential advantages of building active portfolios for clients with low cost, transparent, and tradable ETFs.

Broadly, we believe that active management has a future, but only if it’s delivered in low-cost products.

One potential source for new active ETFs could be issuers who have yet to enter the market. Notably, some of the largest mutual fund shops have yet to launch an ETF. Research shows that in the past ten years, $829 billion moved into U.S. equity funds in the lowest-cost quartile, while $893 billion exited all other U.S. equity funds.3 Therefore, if active management is available in a low-cost wrapper, we see a bright future for active ETFs.


Active and passive, not active or passive

Given our belief that active ETFs are likely to become more prominent, we need to answer how active and passive approaches work together. To begin, the idea that an investor must choose either active or passive is overly simplistic and outdated.

Some clients might favor passive approaches, others might want only active strategies, and some may want a combination of both. Our colleagues in Vanguard Investment Strategy Group recently produced a paper providing a framework for active and passive decision-making that sheds light on the key considerations.4

How you balance active and passive strategies is a decision between you and your clients. Our aim is to help you expand your tool kit with low cost products that help you help your clients meet their objectives.

2 Based on data, as of February 28, 2018.
3 Vanguard calculations, based on data from Morningstar, Inc. Expense ratio quartiles were calculated annually. Each quartile represented 2016 asset-weighted average expense ratios, determined by multiplying annual expense ratios by year-end assets under management and dividing the aggregate assets in each quartile. Data cover the ten years ended December 31, 2017.
4 Daniel W. Wallick, Brian R. Wimmer, Christos Tasopoulous, James Balsamo, and Joshua M. Hirt, 2017. Making the implicit explicit: A framework for the active-passive decision. Valley Forge, Pa.: The Vanguard Group.

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Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal.

Diversification does not ensure a profit or protect against a loss.

© 2018 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. U.S. Patent Nos. 6,879,964; 7,337,138; 7,720,749; 7,925,573; 8,090,646; and 8,417,623.



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