The ETF industry has witnessed a number of new active ETF product introductions. As of last week, 44 of the 161 ETFs launched this year were active as tracked by First Bridge Data.
But what marketing strategies could be most effective for active managers when gathering ETF assets? A marketing strategy that challenges traditional beta, market cap weighted ETFs as core holdings in existing ETF portfolios won't work say industry experts.
Instead, active ETF fund managers should target investors who are heavy users of index-based strategy ETFs and also emphasize tax and efficiency benefits to users of traditional active mutual funds who are considering migrating to ETFs.
Industry practice dictates that active fund managers are evaluated relative to their benchmarks (such as the S&P 500 for equities, Barclays Aggregate for bonds, etc.) These managers usually choose between two broad approaches to marketing their funds: I term them "superior strategy" and "star manager." The former emphasizes a strategy that can beat the market due to a proprietary methodology, a presumed inefficiency in the asset class, or both. The latter emphasizes the specialized domain expertise and reputation of a specific individual manager. When active managers enter the ETF space, their natural tendency is to take one of these two approaches.
However, successfully going head-to-head against index-linked market cap weighted ETFs with these arguments will prove difficult to execute, given the current "state of play" in the ETF market. Let us examine the marketing messages that the fund manager would make under the superior strategy and star manager approaches.
In the superior strategy approach, the first assumption is that there are specific asset classes that are inefficient or illiquid and therefore lend themselves better to active management. Historically, fund managers have argued this in small caps and emerging equities, suggesting that because these asset classes were more inefficient due to information asymmetry or poor liquidity, they were better suited to active management. Another route in the superior strategy approach is to operate in a traditional asset class, such as U.S. equities, but possess a proprietary investment strategy that investors are not currently able to access.
For example, providing exposure to a specific investment factor (e.g., high quality or dividends), but through a unique and proprietary, active approach to screening and weighting the securities.
Over the last few years, it has become increasingly difficult to make this superior strategy argument. Index providers like S&P Dow Jones have produced reports for several years showing that even in supposedly less efficient asset classes, active managers find it hard to consistently beat their index benchmarks.
In the star manager approach, the sponsor makes similar arguments. This marketing message de-emphasizes a specific methodology and focuses more on the reputation of key individuals. However, this approach suffers from the same problem as the superior strategy approach: fund managers have to demonstrate that they can beat their benchmarks across all market conditions. Additionally, as demonstrated recently in Bill Gross's sudden departure from Pimco, if the star manager leaves, it can have negative implications for both the firm's brand and asset flows, at least in the short term.
The core retail users of traditional ETFs today are still investors who are more predisposed to passive investing. So persuading them with the superior strategy or star manager messaging is unlikely to be successful.
A BETTER APPROACH
If head-on competition with passive, market cap weighted ETFs is not a good idea, what strategies can managers of active ETFs adopt?
* Target users of rules based strategy ETFs. As of Q3 2014, there was over $170 billion in assets in non-traditional 'smart beta' ETFs in U.S. listed equity ETFs alone according to First Bridge Data. Users of these products generally are skeptical of traditional market cap weighting. For example, a lot of investors in fundamentally weighted ETFs believe that traditional market cap weighting can result in performance drag since it results in over-weighting potentially over-valued stocks and under-weighting potentially under-valued stocks. They are not traditional passive investors - in fact, rules-based ETFs are really active products in an index wrapper, since they don't hold the cap-weighted market portfolio. These investors are more likely to be receptive to active, non-indexed ETFs, provided the products are not uncompetitive on pricing, tax efficiency and turnover compared to rules based strategy ETFs.
* Directly target users of traditional active mutual funds. Though the ETF industry in the U.S. ended September with $1.865 trillion in assets according to First Bridge Data, it is still smaller than the traditional active mutual fund market. Investors in those products are increasingly likely to consider migrating to ETFs. This would set up the managers of active ETFs to gather some of this fund flow by emphasizing tax efficiency and potentially lowering costs. This is a very distinct marketing message and emphasis that taking on traditional beta products and emphasizing performance relative to them.
We are very likely to see the introduction of more active ETFs in the United States in the next 12 to 18 months. Sponsors of these funds that try to take on traditional cap weighted beta ETFs by emphasizing superior strategy or star manager messaging will likely face headwinds. Instead, these managers should consider making a very targeted pitch at users of rules-based smart beta strategy ETFs and also users of traditional active mutual funds who are likely to migrate to ETFs.
Aniket Ullal is the founder and CEO of First Bridge Data.