While the bread-and-butter of the ETF industry has been index-tracking products, active ETFs are quickly growing in popularity as several funds have gained critical mass with investors. There were 61 active ETFs trough the end of April with a combined $14 billion in assets under management. These funds have allowed retail investors to apply professional management to a variety of asset classes and strategies.
What’s the Appeal?
For investors, there’s a lot to like about active ETFs. First, given the markets heavy volatility over the last few years, active ETFs that are managed by a professional can shift allocations and positions according to the economic environment.
Recent studies have shown that managers with high “active shares”––or the percentage of a fund’s weight-adjusted portfolio that differs from its benchmark––can produce extra returns for portfolios. Typically, active ETFs have an alpha-seeking objective and are designed to “beat the market.” Those extra returns can mean a great deal when the market is moving sideways.
Secondly, active ETFs make a great substitute for mutual funds. Active ETF fees are often less expensive than mutual funds in the same Morningstar category. And this extends to esoteric asset classes normally reserved for high-net-worth individuals, which are only accessed through separate managed accounts [see our Mutual Fund To ETF Converter].
Finally, like index ETFs, investors can gain access to superstar managers with lower initial investments. For example, bond king Bill Gross’s and Pimco’s flagship Total Return Fund requires an initial investment of $1,000 or more depending on the share class. The PIMCO’s Total Return ETF (BOND), also managed by Bill Gross in a similar style, can be purchased for around $110. This lower initial investment makes it more widely available to smaller investors.
How Much Will It Cost?
Though active ETFs are typically more expensive than passive index ETFs, they are still considerably cheaper than actively managed mutual funds. According to the latest Investment Company Institute (ICI) report, the average mutual fund investor––including index funds––paid 1.07% in expenses last year. That doesn’t even include the average 5.73% sales load.
For active ETF investors, these costs are much lower. For example, both the Guggenheim Enhanced Core Bond (GIY) and Guggenheim Enhanced Short Duration Bond ETF (GSY) can be had for only 0.27% in expenses.
Are They Worth It?
Actively managed ETFs have higher fees than your normal index fund expense ratios, so investors expect actively managed ETFs to outperform or beat the market. As with any fund, that potential outperformance comes down to just how good the underlying managers are. Just as in the mutual fund world, there are plenty of stinker funds. However, there are managers and active ETFs that have beaten their respective benchmark indexes consistently – some by a wide margin.
For example, the Peritus High Yield ETF (HYLD), which bets on junk-bonds, beat its rival iShares iBoxx $ High Yield Corporate Bond (HYG) by almost 3% in 2012. It also pays a much higher dividend.
Another example is the aforementioned Pimco Total Return ETF. The fund’s smaller size has allowed Bill Gross to be more nimble, which has translated to big returns. The fund has returned roughly 11% since its launch in February 2012.
The Bottom Line
For investors, there is a lot to like about active ETFs––lower expense ratios, lower initial investments and professional management make them perfect substitutes for mutual funds. The active management can result in higher and benchmark-beating returns, but investors need to take a close look under the hood of all of their ETF options to find the perfect balance of risk, reward and costs before investing.
Aaron Levitt writes for ETFdb, which offers a comprehensive and original ETF database and analytical consulting services for advisors and investors, as well as a free newsletter. Learn more about their services by visiting ETFdb.com. Disclosure: the author had no positions in the securities named in this article at the time of writing.