What is an "active" ETF and what advantages does it bring to ETF and mutual fund managers and more importantly investors? ETFs in the U.S. are structured as funds following guidelines under the Securities and Exchange Commission 1940 Act regulations with some exemptions , and although these ETFs account for only 9.8% of all mutual funds assets, they have been growing at a rate of 28.9% a year over the past 10 years which is faster than other types of mutual funds.
The first active ETF in the U.S. was launched in 2004 while the first index tracking ETF was launched in 1993. The ETF/ETP industry in the U.S. had 1,525 products with assets of $1.94 trillion from 57 providers at the end of October 2013, of which 68 were active ETFs/ETPs with $14.9 billion in assets or less than 1% of the ETF/ETP industry.
The questions around active ETFs are interesting. Is this move into active a defensive move by mutual funds to thwart the perceived threat of ETFs which have been called a disruptive innovation by trying to imitate ETFs - or is the ETF industry trying to absorb traditional mutual funds?
Characteristics of index tracking ETFs:
* Transparency - typically the full list of holdings are published daily.
* Flexibility — trade and settle like stocks, with intraday pricing and trading, place stop and limit orders, increments of one share and go long or short like a stock.
* Cost effective — asset weighted average TER for ETFs is 0.3%.
* Tax efficient — low portfolio turnover and the in-kind creation/redemption process
* Diversification — exposure to an entire benchmark.
* Indicative NAV — real-time value of the underlying portfolio
* Liquidity — two sources: secondary, volume on exchange and primary, in-kind creation/redemption process trading the underlying holdings by authorised participants. Indicative NAV these sources of liquidity keep ETFs trading with tight spreads and around their NAV.
To begin to understand this we must first consider what "active" actually means. Active funds refer to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a specific benchmark and hence delivering alpha. Active ETFs are not ETFs that are designed to track nonmarket cap indices as some commentators have suggested.
We have years of historic data illustrating how difficult it is to find traditional active funds which consistently deliver alpha. There is no guarantee that the performance of active ETFs will deliver consistent alpha.
In the U.S., the SEC requires ETFs to provide transparency of their holdings and defines, active ETFs as funds that do not track an index. Successful active equity managers are less willing to provide transparency on their "secret sauce". Some less well known active equity managers have been willing to run active ETFs with full transparency. These products have had limited success in raising assets and some have been closed.
Well known fixed income managers are more likely to offer transparent active ETFs as the benchmarks are much larger and bond investment strategies are harder to copy. Just three of the 68 active products have gathered over $1 billion in assets: PIMCO Enhanced Short Maturity Strategy Fund (MINT) with $3.889 billion, PIMCO Total Return Exchange-Traded Fund (BOND) with $3.835 billion and WisdomTree Emerging Markets Local Debt Fund (ELD) $1.350 billion. These three active ETFs account for 60% of all of the active assets.
A number of existing ETF managers and traditional active mutual managers in the U.S. have been trying for about five years in some cases to gain permission from the SEC to allow them to manage non-transparent active ETFs. Proxy portfolios designed to mimic the performance of the real holdings while disguising the ETF's actual holdings and transparency on a quarterly basis both without in-kind creation/redemption. Navigate Fund Solutions (part of Eaton Vance) is working on developing exchange-traded managed funds, or ETMFs, which will be active non-transparent funds that trade based on a reference to future NAV.
ETFs/ETPs are a product category where mutual fund managers have to decide if they want to participate as a manufacturer of index or active products or if they want to create and offer products that use ETFs as building blocks to deliver desired exposures and returns.
Deborah Fuhr is the managing partner and co-founder of ETFGI, an independent research and consultancy firm established in 2012 offering research on global ETF and ETP industry trends and all products. Previously she was the global head of ETF research and implementation strategy and a managing director at BlackRock/BGI.