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.