Next-Gen ETFs Debut Amid Pandemic

[This article appears in our July/August 2020 issue of ETF Report.]

After more than a decade of anticipation and delays, the first nontransparent active ETFs launched in the first quarter of this year.

So far, however, these long-awaited funds have struggled to attract investor enthusiasm, with only one of the funds breaking $100 million in assets under management (AUM) and barely any organic growth in sight.

Normally, that wouldn’t be a big deal; plenty of ETFs have lackluster launches, only to build steam and assets as the months and years pass.

But issuers’ main argument in favor of the nontransparent active ETF structure was that there was pent-up investor demand for the kinds of proprietary alpha-generating strategies that only these novel vehicles could unlock. Investors, they argued, were asking for—begging for—their unique active management strategies, which could only be brought to the ETF market by concealing daily portfolio holdings.

However, that demand doesn’t seem to have manifested yet.

Only 1 Nontransparent Active ETF Cracks $100M
As of print time, there are now six nontransparent active ETFs on the market: three licensing the Precidian structure and three from Fidelity using its proprietary model.

At $131 million in AUM, the American Century Focused Dynamic Growth ETF (FDG) is the largest of the six, followed by the American Century Focused Large Cap Value ETF (FLV), which has $74 million in assets.

The remaining four all have less than $25 million in assets—combined (see Figure 1).

To be sure, FDG’s $131 million in AUM isn’t chump change—it’s solidly past the $100 million threshold that signals a well-established fund, and well within range of American Century’s other transparent ETF offerings. But consider its size compared to the $247 billion tied to growth ETFs using the usual transparent structure; or even the $118 billion invested in transparent active ETFs.

What’s more, the majority of FDG’s assets likely came from a single investor, who injected $95 million into the ETF on a single day in June (see Figure 2).

That same day, FLV saw a similar spike in flows, a $64 million influx that accounts for 86% of the fund’s total net assets (see Figure 3).

Assets are assets, of course, but spiky one-day flows do not lend much credence to the idea that there was pent-up demand among ETF investors for nontransparent active products.

As for the other four nontransparent active funds, only the Fidelity Blue Chip Growth ETF (FBCG) has shown any indication of organic growth, with regular inflows most days since its launch. Still, at $13.8 million, assets in FBCG remain small (see Figure 4).

Good Performance Not Getting Much Enthusiasm
Ironically, FLV and FDG actually delivered (somewhat) on the promise of active management, which is to say that they held their own in a volatile market.

Since inception, FLV and FDG are up 12% and 42%, respectively. Now, that’s largely a quirk of lucky timing: The two ETFs launched on March 31, near the bottom of the market’s nosedive, so there was little place for those funds to move but up.

Even still, their performance is as good or better than other benchmark funds in their respective spaces. The largest value ETF, the Vanguard Value ETF (VTV), was up 13% over the same period, compared to FLV’s 12%.

Meanwhile, FDG substantially outpaced the largest growth ETF, the Vanguard Growth ETF (VUG), which rose 29% compared to FDG’s 42%.

The other four ETFs, which launched over a month later, have a more mixed track record. The best performer is the Fidelity Blue Chip Value ETF (FBCV), which rose 4.4%, while the worst performer is FBCG, which fell 5.4%. (However, we caution readers to take this data with a grain of salt, as it’s almost meaningless to compare track records with such a short time frame.)

Clones Of Existing Mutual Funds
Most of the current crop of nontransparent active ETFs are essentially clones of existing mutual funds, just with minor tweaks. (The lone exception is FLV, for which American Century offers no comparable mutual fund.)

For example, FDG is structurally and strategically similar to the $502 million American Century Focused Dynamic Growth Fund (ACFOX), which launched in 2006; ACFOX and FDG even share the same portfolio manager. However, FDG has a slightly wider scope, stretching into the U.S. midcap space for growth stocks, while ACFOX limits itself to just U.S. large caps.

Of course, the biggest difference between the two funds is that FDG costs 0.45% in expense ratio, nearly half that of ACFOX, which costs 0.85% for its Investor class shares. ACFOX also requires an investment minimum of $1,000 for retirement accounts and higher for nonretirement counts, though the minimum can be waived for special circumstances.

The Legg Mason and Fidelity nontransparent active ETFs are also substantially cheaper than their mutual fund counterparts. For example, the ClearBridge Focus Value ETF (CFCV), which is very close to the $1.5 billion ClearBridge Large Cap Value Fund (SINAX) (the two also share a portfolio manager), costs 0.50% compared to SINAX’s 0.88% (see Figure 5).

Mutual Funds See Asset Growth
One might be tempted to blame nontransparent active ETFs’ anemic flows on March’s historic market nosedive—after all, many investors pulled money from the market in the worst sell-off we’d seen since the financial crisis.

Still, logic dictates that a market downturn should have increased demand for these ETFs, not repressed it. After all, active management’s raison d’etre is alpha: A competent manager should be able to protect investors from the worst of a downturn, by harnessing alpha on their behalf.

And in fact, we did see assets in four of the five comparable mutual funds increase over the same time period that their ETF counterparts were on the market (see Figure 6).

Right Product, Wrong Audience?
For what it’s worth, there is appetite for active management among ETF investors: Well-known managers such as PIMCO and ARK have managed to carve out billion-
dollar niches for their proprietary strategies. But the portfolios of their ETFs are fully transparent, with updated holdings published to their fund websites daily.

So the lack of enthusiasm for nontransparent active ETFs may just be a case of the right product for the wrong audience. After having portfolio transparency available to them for so long—indeed, with portfolio transparency often being lauded as one of the main advantages of ETFs—investors may be loath to give it up, no matter how well-performing a particular active strategy might be.

Further, ETFs have largely been used by investors interested in passive strategies. For these new types of ETFs to really take off, a new cohort of investors interested in traditional active management might have to enter the ETF space.

Bottom line? It’s early days for nontransparent active ETFs, and perhaps, like many ETFs, they just need a little time and word of mouth to accrue meaningful assets. It could still happen!

As with all new investment ideas, only time will tell.