With all sorts of innovations, strategies and would-be issuers gathering at the gates, will actively managed ETFs finally get a true foothold in the marketplace?
[This article opriginally appeared in the May issue of ETF Report.]
Scuttlebutt in the ETF industry is full of predictions about how already-rapid growth in the world of U.S-listed exchange-traded funds is likely to accelerate in the coming years. Behind much of that optimism is the belief that active ETFs are the "next big thing" in the 21-year-old world of ETFs.
After all, the pure-index ETFs that began coming to market in the 1990s, beginning with the SPDR S&P 500 ETF (SPY | A-98), may have reached the zenith of their popularity, so the argument goes. Indeed, the low-cost, "pure beta" segment of the ETF market does seem pretty much accounted for by the likes of Vanguard, Schwab, State Street and even iShares, with its inexpensive lineup of "Core" ETFs.
Furthermore, the world of quasi-active "smart beta" funds built on indexes designed to beat the market from Research Affiliates and WisdomTree or even the PowerShares ETFs using Dorsey, Wright relative-strength screens, are now getting serious attention from investors, setting the stage, the soothsayers say, for bona fide active strategies to get serious traction as well.
"There is a population that will always want to try to get some alpha, and they can use these 'active' smart-beta strategies," said Deborah Fuhr, an ETF industry analyst who runs the London-based consultancy ETFGI. She stressed that broadening the definition of what constitutes active management is crucial to fully understand and take measure of the still-developing active ETF phenomenon.
Fuhr said those who choose active ETFs are probably not the same investors who have used the index-based ETFs that have been popular so far. But she was reluctant to prognosticate to what extent active ETF adoption would accelerate.
"Transparent" active ETFs already exist, though they haven't yet taken off in any meaningful way in terms of assets under management. A total of 85 actively managed ETFs are now listed in the U.S., or about 5% of the 1,570 U.S. ETFs (Figure 1). But less than 1% of the $1.7 trillion in ETF assets are in active ETFs, which are "transparent" in that they must disclose portfolio holdings daily.
Active Bright Spots
The most successful active ETF strategies to date have been focused on fixed income, and the two biggest, both from Pimco (Figure 2), command about half of the $15 billion now invested in active ETFs. Those are the $4 billion Pimco Enhanced Short Maturity Strategy Fund (MINT | A), the No. 1 active ETF, and Bill Gross' $3.42 billion Pimco Total Return ETF (BOND), the ETF version of his Pimco Total Return Fund, the mutual fund behemoth that has $236 billion in assets.
Besides Gross' star power and Pimco's marketing muscle, there's also a clear sense that active bond funds have a receptive audience given both the ultra-low yields that have prevailed since the market crash of 2008, and the droves of retiring baby boomers who absolutely need income from their investments.
Active managers have a clear opportunity to deliver yield and to outperform bond indexes, and advisors are scouring the landscape to find creative ways to help their clients.
Global Financial Private Capital, a Sarasota, Fla.-based advisory firm, is the single-biggest owner of the AdvisorShares Newfleet Multi-Sector Income ETF (MINC | C)—a one-year-old active fund with $109 million in assets. It can serve as a money market proxy, but its manager does fish for credit risk in a portfolio with duration between one and three years, explaining a yield that's often above 3%.
"It fills a need—demand for this type of an instrument is only increasing, because the segment of the population that needs it cannot tolerate anything else," said Chris Bertelsen, chief investment officer at Global Financial, which has 10% of its $3.4 billion in assets under management in ETFs.
"I get calls from people all the time that have maturing CDs, and they tell me: 'I can't take it anymore,'" Bertelsen said about the real-world effects of low rates on investors, adding that MINC was a solid solution for those looking for decent yield without taking on irresponsible credit or interest-rate risk.
Pimco's MINT—again, the biggest active ETF in the world—is a bona fide money market fund replacement with duration of no more than one year, and its success also suggests the joint thirst for extra yield without sacrificing safety that Bertelsen says motivates so many investors these days.
Hopes And Challenges
Fuhr reckons that star power and deep pockets—like Gross' and Pimco's—are going to be necessary to move the needle in an industry that has changed quite a bit since the glory days of stock-picking managers such as Peter Lynch. He ran the Fidelity Magellan Fund from 1977 to 1990, lifting it from unknown to poster child for the stunning success of active open-end mutual funds.
Active ETF rollouts have accelerated significantly in the past two years (Figure 3), and huge asset active managers such as J.P. Morgan are on the verge of joining the space in the ETF industry.
The presence of J.P. Morgan, with its considerable marketing capacity, might help validate claims of fund industry professionals who say investors are eager to embrace active ETFs. In addition, consultancies such as McKinsey & Co. predict assets in active ETFs will grow sharply in the coming years.
However, the next accelerant may lie in bold new plans to bring nontransparent active ETFs to market that won't require fund managers to disclose portfolio holdings every day, thereby protecting their best ideas.
That said, a number of sticking points stand in the way of active management that are likely to slow—if not halt—the more widespread adoption of active ETFs. Not least among those challenges is that many investors now question the value of active management, relative to cheap and transparent index ETFs.
Considerable buzz these days surrounds two efforts in the ETF industry to bring to investors so-called nontransparent ETFs that will only have to disclose portfolio holdings quarterly. But as of this writing, neither idea had yet been approved by the Securities and Exchange Commission.
Proponents of active investing see the preservation of a manager’s “secret sauce” as the holy grail of investing. Their argument is that active strategies that must disclose portfolio holdings daily are effectively allowing competitors to see their alpha-generating ideas each and every day, possibly exposing them to front-running and copycats.
One of the nontransparent efforts is being championed by Boston-based Eaton Vance. The firm plans to replicate its entire mutual fund lineup in a new vehicle it is calling the exchange-traded managed fund.
The “ETMF” will enable investors to trade intraday, but each trade wouldn’t settle—as is the case with mutual fund trades—until after the market close. If this makes the ETMF sounds like a mutual fund, it’s because it is like a mutual fund.
But it’s also like an ETF to the extent that all the fund trading will be done by authorized participants (APs) and not by Eaton Vance’s internal trading desk. There also won’t be any 12b(1) marketing fees attached to them. Those fees, which are part of the expense ratios investors pay on a given mutual fund—ETFs generally do not have them—are devoted to marketing particular strategies.
Eaton Vance says it will save investors 50 basis points, or $50 per $10,000 in management fees, each year—real money in a world characterized by falling costs.
However, nixing 12(b)1 fees is a “deeply disruptive” idea that could hurt the ETMF’s prospects, according to Nicholas Colas, chief market strategist for the New York-based brokerage firm ConvergEx Group.
“There’s a big part of the financial services industry that’s anchored around 12b(1) fees. By removing them, how do you compensate people for marketing one product versus another?” Colas asked, saying the question of 12(b)1 fees came up again and again after a recent Eaton Vance presentation on the ETMF to various Wall Street players.
The other big idea that’s been coursing through the SEC for the better part of three years is a nontransparent ETF that would keep its portfolio holdings concealed through the use of a blind trust at the center of the creation/redemption mechanism.
APs for the products would be doing creations and redemptions for cash and hedging the funds based on the fact that they could redeem shares for the exact cash value of the funds’ net asset value. Within the blind trust, creations and redemptions would happen in-kind, allowing the fund to enjoy some of the tax efficiencies that transparent ETFs currently enjoy.
Crucially, the blind trust would be able to do what APs at the center of any index-based ETF are able to do as well, such as eliminating higher-cost securities to get rid of embedded capital gains at the fund level. Such cherry-picking of securities is a key reason ETFs are considered to be more tax efficient than mutual funds.
Precidian Investments, the money management firm with the patent to run active ETFs this way, has two major parties that have licensed the idea: none other than the world’s two biggest ETF companies—BlackRock’s iShares and State Street Global Advisors. Both ETF firms, armed with the patent from Precidian, have petitioned the SEC to earn the legal right to market these proposed active ETFs.
Adding to the sense that this idea may have legs is that Precidian itself, which has also petitioned the SEC to market funds using its own idea, has filed a separate registration statement detailing three nontransparent, active U.S.-focused equity funds.
The Precidian registration statement is a case of putting the cart ahead of the horse. But industry chatter suggests that both the Eaton Vance and the Precidian plans are close to being approved by the SEC, implying that registering actual funds before the approval of the idea isn’t just wishful thinking.
If that is indeed the case, then investors will, at the very least, be subject to sales and marketing efforts worthy of the biggest and most influential fund companies in the world, including Wall Street stalwarts like J.P. Morgan.
What’s Active, Anyway?
But then again, there is a question of what, exactly, constitutes active asset management. A lot has changed, as noted, since the Magellan Fund’s halcyon era, from the increasing popularity of quasi-active “smart beta” strategies that are designed to beat broad cap-weighted indexes, to the fact that index ETFs are increasingly being used as building blocks for active asset allocation.
Upward of $200 billion in ETF assets are now in smart-beta funds. That’s around 12% of all ETF assets, and investor interest in fundamental indexing and broad funds like the PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-88) and in other rules-based factor tilts is only growing.
“I don’t particularly like the name ‘smart beta,’ but I do think there are investors who feel disenfranchised and don’t necessarily believe that most managers can outperform,” said Fuhr.
Additionally, one of the fastest-growing pockets in the world of exchange-traded funds is the realm of “ETF strategists,” who, by and large, use index ETFs to deliver outperformance to their clients. Even Vanguard, an index shop at its core, began talking to investors in the past year about ways to use its plain-vanilla, cap-weighted index ETFs to formulate top-down alpha-seeking tilts.
“We don’t have any interest in active ETFs, because when we buy an ETF, we want pure exposure,” said Brian Schreiner, president of Pa.-based Schreiner Capital Management, echoing a sentiment of many ETF-focused money managers. But Schreiner says that, on rare occasions, his firm has made use of “smart-beta” tilts.
Perhaps most damning to the outlook for active ETFs is that many investors have grown skeptical that active managers can indeed outperform their benchmarks over time.
The Standard & Poor’s Index Versus Active (SPIVA) report that comes out twice a year pretty much tells a variation of the same tale every six months; namely, that only about one-third of active managers beat competing indexes in any given year, and that outperformance number drops over time. In other words, it’s hard to beat an index, and it’s even harder to keep beating an index over time.
“There are a lot of data out there that say that actively managed strategies have challenges—to put it politely—beating their respective benchmarks,” S&P Capital IQ’s Rosenbluth said.
“The investors who have gone on the ETF route have gone there for the passive approach—an ‘if you can’t beat them, join them in going with the index’ sort of thing, and there’s certainly merit behind that,” he noted.
All these data don’t mean that active management doesn’t work. It can and does, from time to time.
Stars And Necessity
The star quality litmus test will certainly come into focus when J.P. Morgan, a firm solidly associated with active management, shows its hand in the world of active ETFs. If any firm can get traction in offering active ETFs or quasi-active smart-beta ETFs, one of the world’s biggest banks is it.
Also, the question of three- and five-year track records looms large. The recent acceleration of asset growth at First Trust suggests as much. The Wheaton, Ill.-based fund firm pulled in $3.6 billion in the first quarter of this year—or 15% of all its assets—much of those assets flooding into both its smart-beta products like its AlphaDex line and its transparent actively managed securities.
Finally, it’s important not to lose sight of the necessity—yes, the necessity—of speculation and price discovery that active investors bring to financial markets. Not only will active management invariably be part of the future, it has to be, as star financial advisor Ric Edelman makes plain.
“While I disagree with the premise of outperformance that active managers use to promote their approach, I do acknowledge that without their presence, the passive strategy cannot exist,” Edelman said. “It’s the yin to the yang.”