The low cost leader in the mutual fund and index ETF space now appears to be taking aim at active ETFs.

Mutual fund giant Vanguard is seeking SEC permission to issue actively managed ETFs. In a March 7 filing with the agency, Vanguard said it was seeking permission to issue active ETFs on existing funds - a list that could include the Vanguard Explorer Fund and Vanguard Wellington Fund, as well as bond index and municipal bond funds.

"This move will put pressure on existing active ETF providers and create even greater cost advantages for active ETFs versus active mutual funds. To compete, providers will need to improve their distribution strategies by offering advisors additional reasons to do business with them, such as tools and education for their clients and help for advisors to build their practice," says Christian Magoon, founder of YieldShares. At the same time, he says, it's important that a strong retail brand like Vanguard is embracing the emerging area of active ETFs. According to Magoon, while PIMCO has found a lot of success in active ETF products for fixed income, the equity space hasn't really taken off in a big way. Vanguard's reputation and resources could jumpstart the active ETF segment when it comes to equities and that will make a lot of providers nervous, he says.

Any move forward is still far off, Vanguard notes. "Vanguard has no immediate plans to offer active ETFs. There is no guarantee the SEC will grant our application, and if it does, no fund could offer an actively managed ETF share class until that particular fund's board has approved such an action," Vanguard spokesman David Hoffman says.

Even if the SEC approves the firm's application, it is likely to take at least 12 months before an actively managed ETF launch. Still, mutual fund and ETF providers have active ETFs in the pipeline and this latest move by Vanguard may alter their distribution and pricing strategy.


Some managers note that the extra level of fees that investors would need to pay in order to have the actively managed ETF wrapper may not be worth it and would detract from the firm's ultralow-cost philosophy. "I think this move is contrary to the long-term trend of passive investment, but for those managers who use active management, more choices are always a good thing," says Ron Rhoades, a professor at Alfred State College's financial planning program in Alfred, N.Y. He adds that Vanguard's inclusion in the actively managed ETF arena may aid some actively managed funds to become more tax efficient. Whether low-cost actively managed ETFs from Vanguard will be able to consistently outperform their benchmarks over the long-term remains to be seen, and if outperformance does occur, it likely won't be substantial, Rhoades says. The veteran planner identifies himself as a strict proponent of passive investing and says he would only use passively managed funds or ETFs from Vanguard.

"Vanguard is always the one pushing the envelope," adds planner Cathy Curtis of Oakland, Calif. "Perhaps Vanguard doesn't want to be trumped by S&P or iShares again." She also identifies herself as a strictly passive proponent.


Regardless of whether the SEC approves Vanguard's request, the move reflects the increasing popularity of ETFs among managers, advisors and investors, says Brian Bush, executive vice president of wealth management firm Stephens. Advisor use of ETFs grew at an annual rate of about 27% during the five-year period through 2012, according to research firm Cerulli Associates. ETFs accounted for $170 billion of the RIA channel's assets by year-end 2012, or 7.4% of the channel's overall assets.

Judging from the embrace of ETFs in recent years, Vanguard's decision to seek SEC permission to issue actively managed ETFs is a market share move by the mutual fund company, Bush says. Fidelity entered the ETF market last year and now Vanguard is trying to broaden its footprint, he says. "The two giants seem to be coalescing together in the ETF space, but coming at if from very different origins: Vanguard is the passive index leader and Fidelity is the active fund management leader," Bush says. "It will be interesting to see if the fees and expenses on actively managed funds will be different in the ETF form compared to their existing open-end products - because it seems they would be cannibalizing to some degree their existing fund offerings," he adds.


Many would agree Vanguard's success and industry dominance stems from good timing and smart decisions. In 1976, the firm created the first index mutual fund, switching from a broker distribution system to a no-load system in 1977. The firm also developed a defined-maturity bond fund strategy that year. At the end of February, Vanguard had 67 ETFs with $345.5 billion in assets. A total of 36% of Vanguard's U.S. assets, or more than $860 billion through January, are held in actively managed funds. Vanguard manages 75 active funds in the U.S. - 37 active equity funds, four active balanced funds, 24 active bond funds and 10 active money market funds. The cost advantages from scale yielded an average ETF annual expense ratio of 0.13% for Vanguard ETFs versus 0.61% for the industry as of the end of 2013, according to Lipper. While some fund managers say Vanguard's steps toward offering ETF versions of several of its well-known actively managed mutual funds contrast with its status as a proponent of passive investing, Vanguard views ETFs and mutual funds as two sides of the same coin. "Vanguard has always believed the primary benefits of ETFs are based on their index characteristics - low costs, broad diversification and tax efficiency. However, Vanguard also believes in low-cost, broadly diversified actively managed strategies," Hoffman says.


Vanguard's request to the SEC also follows similar requests by other large asset managers to do the same. BlackRock, State Street, T. Rowe Price, Precidian Investments, Guggenheim Funds and Eaton Vance are a handful of companies that have jumped on the bandwagon to bring active management to equity ETFs. In September 2011, BlackRock the largest provider of ETFs, asked for permission from regulators to offer actively managed ETFs aimed at competing with stock- picking mutual funds. The firm's request has still not been approved by the SEC. "Vanguard's potential move into the actively managed ETF space, if the requisite consents are obtained, is another move to keep Vanguard well-positioned as a mutual fund and ETF marketplace leader," Rhoades says. 

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