When, If Ever, Will Active ETFs Take Off?

July 07, 2015

"The lack of good performance of active managers is because, in a bull market, it's very difficult for an active manager to outperform, and we've had quite a strong bull market recently," Shirbini told us.

The S&P Index Versus Active report would certainly reinforce that point. The report shows year after year that the vast majority of active managers underperform their benchmarks on a regular basis, with only occasional bursts of outperformance.

That track record is exacerbated by the fact that these funds often cost more to own, so they need to deliver bigger returns to make up for the difference.

Consider that you can buy a U.S. stock ETF such as the Schwab U.S. Broad Equity ETF (SCHB | A-100) for as little as 4 basis points (bps), or $4 per $10,000 invested. The cheapest U.S. large-cap exposure in an actively managed wrapper would cost you more than four times as much, and that's cheap by actively managed standards.

Most active ETFs cost anywhere from 50 to 125 bps in expense ratio. Framed another way, it could take more than 30 years of paying that 4 bp annual cost of owning the Schwab ETF to match what you'd pay in one year owning an active ETF.

These challenges are real, and passive smart-beta solutions have offered a viable alternative.

Advisor In The Driver's Seat
ETF strategists are another challenge to the survival of active ETFs. These asset managers extract all the beta they can with cheap passive ETFs, and leave their alpha-seeking ways—offensive and defensive—peripheral to their broad asset allocation approach. Even Vanguard is singing this tune these days.

As of the end of March, Morningstar estimated that ETF strategist portfolios boasted some $86 billion in assets under management. That's about 4 percent of all U.S.-listed assets. What's interesting about the growth of the strategist is that here active management sits at the advisor level rather than at the fund level.

To put in it one tactical ETF strategist's words, "If I were to use actively managed ETFs, what value do I bring to the table?" Combining passive, low-cost strategies with a tactical sensibility is his add-on value. Actively managed funds would defeat his purpose.

Taking On Mutual Funds At Their Game
But there's another problem. Active ETFs have little in the form of a ing machine behind them. Unlike active mutual funds, they don't charge annual 12b-1 fees for marketing and distribution.

Without those 12b-1 fees, it's much harder for managers with good investment ideas who lack the notoriety of a Peter Lynch, of the Fidelity Magellan Fund, to reach much of a public.

Consider that in 2014, investors paid some $13.15 billion in 12b-1 fees for U.S. open-ended mutual funds, according to Morningstar data. That's a lot of money focused on selling these funds.

"The majority of active management is sold, not bought, unlike index based ETFs," Michael McClary, chief investment officer at ValMark Advisers, told us. "As such, the sales force supporting actively managed ETFs is minuscule compared to that selling actively managed mutual funds."

McClary also points out that actively managed ETFs have yet to be adopted "into some of the historic strongholds of actively managed funds, such as 401(k) plans." If they are indeed competing with mutual funds, they have a long way to go if they're to gather serious traction.


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