A New Case For Active ETFs

[If you are interested in learning about active ETFs, join us for our free webinar, “Active Equity: A New Frontier For ETFs” on Thursday, June 25 at 2 p.m. ET. You can register here.]

Actively managed mutual funds are facing powerful headwinds. Years of underperformance and competition from cheaper index funds has led to steady outflows from active mutual funds.

Yet, that same dynamic isn’t playing out in the ETF world. Sure, the vast majority of the $4.5 trillion invested in U.S.-listed ETFs—97.4%—is invested in index-tracking funds. But with $115 billion in assets, active ETFs are a growing force.

The segment got a boost last year after the Securities and Exchange Commission greenlit several semi-transparent and non-transparent ETF models. This year, the first of the ETFs using those models debuted to much fanfare.  

Before these ETFs entered the scene, most active ETFs disclosed their holdings on a daily basis, just like their index-tracking brethren. Most of the money allocated to active ETFs is still in these fully-transparent funds.

However, the launch of new active models opens the door to completely new opportunities for ETF investors and issuers.

Multiple New Models

Altogether, the SEC has approved five new active ETF models. The two which are already in use are the Precidian ActiveShares model and the Fidelity model. Under the Precidian model, ETFs are required to disclose their holdings at least every quarter. The first funds to use this model, a pair of American Century equity ETFs, reveal what they own 15 days after the end of each quarter.

Meanwhile, the latest Fidelity active ETFs disclose their holdings on a monthly basis with a 30-day lag.

Both models take different approaches to ensuring that an ETF’s price stays close to its net asset value. The Precidian model uses an Authorized Participant Representative (APR) to confidentially engage in in-kind creation and redemption activity on behalf of the Authorized Participant (AP).

The Fidelity model uses the traditional AP-led creation/redemption mechanism, but substitutes a “tracking basket” in place of the actual basket of fund holdings. The tracking basket, which is published daily and includes some of the ETF’s holdings as well as other ETFs, is designed to closely track the performance of the fund’s complete portfolio, without giving away all of its positions.

Outperformance Possible

Certainly, there has been a lot of skepticism about active ETFs, especially from passive ETF proponents. The Standard and Poor’s SPIVA report card on active fund performance suggests that between 80% and 90% of active U.S. large cap equity funds have underperformed their benchmarks over the last five and 15 years, respectively.

However, that still means that a small, but not insignificant number of active funds are outperforming the broader markets.

Some pockets of the fixed income markets have fared even better. About 50% and 30% of active funds in the short-term investment-grade bond markets have managed to outperform their benchmark over the past five and 15 years, respectively.

Even before the introduction of semi/non-transparent models, active bond ETFs were quite popular with investors. They currently hold about $87 billion, or more than three-quarters of the assets in active ETFs.

Potential New Entrants

Supporters of active ETFs hope that semi/non-transparent models encourage new funds and investors to enter the space. The opportunity to outperform is seductive, and there will likely always be a set of investors willing to bet on managers who are skilled at security selection and who could beat passive indexes.

The new active models might encourage some of those top tier managers to enter the ETF space, especially equity fund managers, who may have previously been put off by the daily disclosure requirements of exchange-traded funds.

By doing away with those requirements, fund managers are better able to protect their secret sauce and avoid front running by other market participants.

[If you are interested in learning more about active ETFs, join us for our free webinar, “Active Equity: A New Frontier For ETFs” on Thursday, June 25 at 2 p.m. ET. You can register here.]

​Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2