[This article originally appeared in our July issue of ETF Report.]
It's been seven years since the first actively managed ETF came to market, and 127 or so funds later, there's still little to suggest that active management in ETFs is going to get much traction, particularly in the equity space.
Out of $2 trillion-plus in U.S.-listed ETF assets today, less than 1 percent is tied to actively managed funds. The asset-gathering success stories are almost exclusively in income-generating investments such as the PIMCO Total Return (BOND | C) that Bill Gross launched in 2012, which has $2.6 billion in assets under management, or funds tapping into master limited partnerships. There are plenty of active ETFs dwindling on the vine.
Active ETF Hurdles
These funds face several challenges. For starters, actively managed ETFs by design are expected to deliver outperformance, but they often underperform their benchmarks, particularly in bull markets such as the one we've been in for several years now.
Price is another problem. These funds aren't necessarily cheap to own, and we live in a world of downward pressure on cost. They are also fully transparent, unlike the mutual funds they compete against, and that's something that has kept many money managers away from active ETFs. In the world of alpha generation, protecting the secret sauce is a way of life, but the current active ETF wrapper requires daily transparency.
Still, there are plenty of ETF fans out there who want to outperform the market. These investors are finding other ways of meeting that need. The proliferation and increasing adoption of smart-beta ETFs is one of them.
Many would argue smart-beta funds are just another flavor of active management, even if they're primarily passive ETFs. Their appeal relative to active ETFs is simple: Advisors are now the ones "actively" combining these passive wrappers in search of outperformance without needing to worry about active management at a fund level.
There's also a new structure coming to market that may offer a compromise between active ETFs and mutual funds, finally bridging the two worlds with an ETF-like wrapper. Eaton Vance's exchange-traded managed fund (ETMF), which will be marketed as NextShares, already has the likes of Mario Gabelli—head of Gamco and someone who's never touched ETFs before—behind it.
Smart Beta Winning Big
The appeal of smart-beta funds with alpha-seekers is undeniable. These funds essentially use different factors or tilts that historically have been reserved for bona-fide active management, allowing investors the ability to hone in on where they believe opportunities are.
So far this year, 34 new smart-beta ETFs have come to market, or about one out of every three new ETF launches. Of that total, 29 of them are in the equity space—the same asset class where actively managed ETFs seem to struggle the most.
Perhaps more impressive is the amount of assets investors have poured into this space—roughly $40 billion as of the end of May, according to FactSet data. This universe already comprises more than 450 different strategies, where the biggest one has a whopping $29.7 billion in assets. That's traction.
Bull Market & Cost Hurdles
Eric Shirbini, global product specialist with Edhec Risk Institute, is quick to point out that the smart-beta trend is still in its infancy, so it's too soon to pin the unimpressive growth of actively managed ETFs on the impressive rise of smart-beta funds. The problem, he says, hinges on performance—or lack thereof.
"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.
The Nontransparent ETF Wild Card
So what's next for actively managed ETFs? That's hard to tell. Clearly, there are pockets of the market—such as fixed income—where these strategies have found a following, and managers are succeeding in delivering on their ideas.
But there's a good chance active equity ETFs might never really get off the ground. Instead, they could find serious competition in the upcoming nontransparent ETF-like structure Eaton Vance has in the works. The ETMFs that Eaton Vance will simply market as NextShares could be the answer alpha-seekers have been looking for in an ETF wrapper.
The structure offers all the benefits of the active ETF wrapper, but without daily transparency.
If traction is any sign of success, here's a clue: There are already 11 companies signed up to offer ETMFs when they come to market—firms such as American Beacon, Hartford Funds, Victory Capital, Pioneer and Gamco Investors.
It's noteworthy to see people like Gabelli jump on the bandwagon, because until now he has professed himself a nonbeliever in the ETF structure.
"I never really liked the notion of ETFs," said Gabelli, whose firm manages some $45 billion in assets. "They are basically buying a basket of stocks, and we saw what happened in 1999—they kept buying Cisco because it was weighted in the index. That didn't go well."
Market-cap weighting in equity ETFs is only one of the things he dislikes about them. Their passive, replicate-the-index approach is another. If you own a passive U.S. equity fund and the market is going down, you too are going down with it whether you like it or not.
"We would always have this debate with John Bogle about what happens in a down market: Would you ever be able to be up in an ETF? The answer is obviously no," he said.
Research Is Crucial
As a stock picker whose firm's core competency is research, Gabelli argues that accepting the market ride isn't enough, and there are "good bargains" to be found by active managers. But these bargains are best captured when the whole world doesn't have to hear about them. Transparency in the ETF wrapper is another issue.
"We don't want to share our ideas of the world while we're just starting to buy them," Gabelli said. In a mutual fund, portfolio managers can keep their buying and selling quiet until the next round of 13F filings requires them to disclose them. The SEC requires 13F forms be filed within 45 days of the end of a calendar quarter.
Gabelli's convictions are in stark contrast to those of people like Burton Malkiel, Eugene Fama, John Bogle, William Sharpe and a long list of luminaries who believe in extracting value in a passive way. There are plenty of doubters about the whole idea of active ETFs and of ETMFs.
"There is still a lot of work to be done on building the infrastructure for ETMFs," ValMark's McClary said. "I think it's still somewhat unclear whether the players involved are willing to accept that ETMFs are the next Netflix or YouTube, instead of the next LaserDisc."
"I have to think that we will have a better mousetrap to provide liquid active management than the ETMF structure sometime in the next five to 10 years," he added. "Size is the chicken-or-egg problem in the traded investment product business. I think it will take a lot of faith on the side of the investment managers who become the first big buyers of ETMFs."
Changing Business Models
But Eaton Vance, mindful of this vast appetite for outperformance, is hoping NextShares could be the answer for managers like Gabelli who know that lower-cost investing is the future.
"You have to be aware that business models change," Gabelli said.
He would know. The first 39 years of his firm involved a lot of reinvention, going from research for commission dollars, to money management, to hedge funds in the early 1980s, to mutual funds in the mid-80s.
"We are always thinking about how the structure of the way we manage money is changing," he said. "What drove us to nontransparent ETFs is the notion that in the next 39 years of our firm, things are going to change, and this is a change that will work. It's good for the customer in the sense that it's lower cost, and it has tax benefits that traditional mutual funds don't."
Are ETMFs the future? Maybe. Maybe not. But they certainly hold the promise to bring large mutual fund managers to the ETF market doorstep.
"I'm not going to join in the evangelical movement to see what the next step for ETFs is going to be," Gabelli said. "But from a very practical business guy's point of view, with a comparative advantage of also being an investor, at the moment there's an inherent flaw with the mutual fund structure with regard to tax structure. There's an inherent advantage with ETFs in the transfer fee. This is a logical step for us."