The words “actively managed ETF” might seem like an oxymoron in an industry founded on the premise that low-cost investment in passive indexes beats having a fund manager call the shots. But if the SEC allows some exchange-traded funds to limit public viewing of portfolio holdings, which a number of experts predict will happen over the next few months, a slew of actively managed equity ETFs could start hitting the market soon.
“A year ago, I would have questioned whether nontransparent ETFs would ever happen,” says Bill Donahue, a managing director at consulting firm Pricewaterhouse Coopers. “Now, it’s just a question of when. It could be six to nine months, or even sooner. When it happens, it will open the floodgates for others to follow.”
Morningstar’s Robert Goldsborough also sees a new era for active management on the horizon. “The SEC’s moves suggest to us that launches of actively managed nontransparent ETFs could be imminent,” he wrote in a June report. “Should one or more of these proposed structures get the go-ahead from the SEC, we anticipate that the active ETF floodgates could open, and far more traditional fund managers may subsequently seek to roll out their strategies in relatively low-cost, tax-efficient ETF wrappers.”
All this talk of opening floodgates is a result of what appear to be imminent exemptions from SEC transparency rules for some ETFs. In contrast to mutual funds, which must disclose portfolio holdings at least quarterly, the SEC requires exchange-traded funds to publish their positions daily. That requirement makes fund managers uneasy about investors mimicking their trades or front-running positions, and it’s the main reason the 87 actively managed ETFs currently on the market almost always avoid equities and gravitate toward fixed income, currencies or funds of funds.
But that could change quickly if the SEC finally grants exemptive relief to a number of companies hoping to disclose their holdings the way mutual funds do. The companies seeking permission for nontransparent ETFs include industry giants T. Rowe Price, Vanguard, Eaton Vance, State Street and BlackRock, as well as another firm, Precidian Investments. In late July, American Funds, which runs eight of the 20 largest mutual funds in the country, became the latest entrant to join the group when it filed for permission to offer nontransparent ETFs. The proposed offerings include large-cap stock funds, long-short strategies, emerging market funds and dividend-focused strategies.
This would also be welcome news for mutual fund firms, which have been experiencing outflows and losing money to passive index ETFs for the last several years, because it would allow them to add another distribution channel for active management. Donahue says retail investors, who now account for only about 4% of the ETF market, are a particularly fertile area for growth in this market.
If “smart beta” ETFs are any indication, investors seem to be open to the notion of moving beyond plain vanilla indexing, even if the cost of doing so is higher. The market for these ETFs, which include strategies such as fundamental weighting, equal weighting and low volatility, now accounts for about 18% of the total ETF universe, according to Morningstar.
Convincing The Skeptics
The leap from what are essentially quantitative filtering strategies with a catchy label to the more nuanced and subjective world of human decision-making is a big one, and some question whether active management will translate well in the ETF arena. Skeptics include ETF investment professionals who hold firm in the belief that asset allocation decisions and low costs, rather than security selection, drive performance.
“We consider ETFs a proxy for asset classes and sectors, and we’re not interested in buying someone else’s packaging,” says William Ferrell, president of Ferrell Capital Management. “We manage money ourselves. Our strategy is not designed to build on someone else’s expertise.”
Ferrell believes that despite the ETF industry’s focus on transparency, the issue really isn’t all that important, and he says nontransparency may not make a huge difference in the popularity of the funds one way or the other. “Hedge funds have always made a big deal about not wanting people to know about what they are buying or selling. But do people really care all that much? Would they really act on information if they had it?”
Vernon Sumnicht, CEO at Sumnicht & Associates, echoes Ferrell’s skepticism about active management in any format. Ten years ago, he decided to switch from using actively managed mutual funds to a strategy that emphasizes asset allocation with low-cost index ETFs. “Actively managed funds pretty much underperform the index by an amount equal to their annual expense,” he says. “And people don’t even see the hidden trading costs. For me to consider active management in an ETF, I’d have to see something pretty damn special, like a great hedge fund strategy.”
Still, he sees a possible advantage of ETF packaging. “In a bad market, some mutual funds might need to sell stock to meet redemptions, which could generate unintended capital gains tax consequences for investors. ETF investors don’t have to worry about that because of the way they’re structured.”
Will McGough, vice president and portfolio manager at Stadion Asset Management, isn’t closed off to the notion of active management, even though his firm has most of its $5.5 billion in assets under management in ETFs. But he’s deterred from investing in actively managed mutual funds, in part because trades must settle at the end of the day at net asset value.
“ETF intraday trading allows us to leverage our trading expertise, which we can’t do with mutual funds,” he says. “When you’re placing trades for $100 million or more, that’s a big consideration.” McGough says that while he “would certainly consider” a nontransparent actively managed ETF, he’s concerned about how efficient the ETF structure would be in an environment where portfolio holdings are shielded from view from authorized participants, who are key to the creation and redemption of shares. Mindful of such concerns, firms are proposing a variety of solutions to keep the share creation and redemption process humming along smoothly, including blind trusts that would facilitate the in-kind processing of redemption requests for authorized participants.
Even if those structures prove efficient, there will likely be some growing pains. Since many of the ETFs will be similar to existing mutual funds rather than direct offshoots, it will take time for them to build a track record or get a coveted four- or five-star rating. Many financial advisors won’t consider putting money into an actively managed mutual fund until it is at least three years old, and they could apply the same criteria to actively managed ETFs.
Investors expecting fee wars similar to those that have erupted among index ETFs are likely to be disappointed, since sponsors who also have mutual funds have little incentive to cannibalize one part of their business by offering significantly lower internal expenses for another. “In terms of fees, this isn’t going to be a race to the bottom, and these aren’t going to be loss leaders,” says Donahue.
Instead, expense ratios for actively managed ETFs will likely come in somewhere between lower-priced indexed products and higher-cost actively managed mutual funds, although Donahue believes it will probably be closer to the latter. But it’s possible that higher trading costs, such as bid-ask spreads and commissions, could narrow or eliminate any cost advantage the new ETFs might have over actively managed mutual funds.
On the plus side, the ETFs would not experience the “cash drag” of mutual funds, which often keep 3% to 10% of assets in cash equivalents to meet redemptions. Even though that money isn’t really being “managed,” investors still pay a management fee on it anyway. And in rising markets, cash can put a drag on portfolio returns.
According to a study published in the Journal of Indexes by William O’Rielly and Michael Preisano, mutual funds maintained an average cash balance of 6.75% of assets over a 10-year period in the 1990s, and the resulting drag from those positions averaged 83 basis points a year. In five of those 10 years, the cash drag stripped more than 1 percentage point from the returns. Of course, in down markets cash can work to a fund’s advantage, and many financial advisors already take it into account when crafting asset allocation plans.
Tax efficiency is another way the new ETFs have the potential to shine. Because of the ETF structure, actively managed ETFs will likely be more tax efficient than comparable mutual funds, although less so than index funds. But it’s still unclear at this point how robust those advantages will actually turn out to be, or how they will compare with the advantages of actively managed mutual funds, which already employ tax-conscious strategies such as low turnover or prudent loss harvesting.
Nonetheless, despite some open questions, sponsors believe it’s possible that the next chapter for exchange-traded funds could be active management. But given the uncertainty surrounding who will buy these ETFs and whether their anticipated advantages over mutual funds will actually materialize, that chapter could take a while to write.