Exchange traded funds continue to gain in popularity with both retail and institutional investors but actively managed ETFs represent only a tiny fraction of the more than $1.1 trillion in assets trading in U.S. ETFs.
But that number figures to rise, according to S&P equity analyst Tom Graves, as investors look for more creative and aggressive ways to diversify their portfolios and take advantage of underpriced or overpriced stocks and funds that they otherwise might not be able to access.
"We view actively managed ETFs as a hybrid investment vehicles, containing characteristics of both 'passive' index-based ETFs and of actively managed mutual funds," Graves wrote in his latest Trends & Ideas report. "Although we estimate that actively managed ETFs represent less than 5% of all the assets in U.S.-traded ETFs, we see interest on the rise, as evidenced by the amount of assets under management and the interest shown by various fund managers in launching such ETFs."
It's telling that as of mid-May, S&P counted only 33 actively managed ETFs on the market with assets of only about $4.4 billion, but that's more than double the number that were available last year. Still, they represent a tiny percentage of the more than 1,000 ETFs now available and it's telling that the top three ETF providers -- BlackRock, State Street and Vanguard -- thus far have only served up one actively managed ETF even though the trio held 83% of all U.S. ETF assets as the end of April.
Of the 33 actively managed ETFs out there, 90% of their assets were held in either fixed income or currency ETFs, meaning there's an obvious opportunity for providers to put in the time and effort to construct actively managed equity-based ETFs to give investors even more options to either increase their returns or hedge against other investment positions.
S&P found only eight equity-based actively managed ETFs available among the 33 available actively managed ETFs and they held less than $100 million in assets.
Disclosure above all other factors has been the one big obstacle that's kept the big boys out of the game and left the fledgling actively managed ETF landscape to the likes of iShares, PIMCO and WisdomTree.
Because ETF holdings are expected to be disclosed on a daily basis, trading in and out of particular ETFs by a fund manager in an actively traded ETF would be a tip off to other investors looking to front run those moves by trading against those positions.
Any actively managed ETF worth its salt would probably shake up its holdings multiple times a day, creating a daily disclosure reporting nightmare to say nothing of giving others investors and firms a blueprint of the fund's investment strategy -- to use for front running purposes or to simply mimic -- without the hassle and expense of having to do the actual research.
"Such transparency could hinder the ability of an active manager to build a position in an attractively priced security," Graves wrote. "If other investors follow the manager's lead, this could push the price of a security up before the fund manager has time to complete his or her accumulation."
To alleviate at least some of those disclosure concerns, Graves said that firms should consider creating actively managed ETF "funds of funds" comprised of various other ETFs that therefore would lessen then importance of day-to-day changes in how much of any one of the constituent ETFs owns of a particular stock.
Of course, another sticking point for investors is because the few actively managed ETFs that exist are only two or three years old at the most, there's no real performance track record to attract investors to generate the demand that would justify creating them in the first place.
Indeed one of -- if not THE -- greatest benefit of an ETF is that investors only incur capital gains taxes when the fund is sold unlike a mutual fund were capital gain taxes are racked up as the individual shares within the fund are sold throughout the lifetime of the investment.
Throw in the fact that these actively managed ETFs by definition are going to cost more because of the research and trading overhead involved, it's easy to see why actively managed ETFs are still struggling to take flight.
Graves thinks providers might be able to make a better case for actively managed ETFs and spur some serious demand if they're willing to offer an initial discount -- banking on the "if you build it, they will come" mantra.
"We think that some actively managed ETF providers might offer an artificially low expense ratio initially, with the hope of attracting assets," he wrote. "Then, if enough critical mass is reached, a fuller reflection of the ETF's costs could be better absorbed in the expense ratio borne by investors."
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