To date, there are about a dozen actively managed ETFs trading on the market, and about twice as many in the pipeline waiting for regulatory approval.
Of the roughly 22 different companies that currently have filings for active ETFs with the SEC, quite a large number of them represent “placeholder” filings where the exemptive relief would allow the company to launch “future funds” with any investment strategy under the sun. As these mutual fund companies and ETF issuers get a better grasp of what strategies are in demand within actively managed ETFs, we will likely see more specific product filings and preliminary prospectus being filed.
The Drawbacks of Actively Managed ETFs
Actively managed ETFs aren’t perfect. It’s a segment of the ETF industry that is still in its infancy. A few of the issues include:
- It’s a Small Market. Actively managed ETFs are not very heavily traded relative to the rest of the ETF space, so you need to watch the bid/ask and work trades in such a way that it doesn’t cause huge spikes in trading volume or price. You should contact your broker or liquidity provider for very large trades.
- They’re More Expensive. Because you’re paying a manager in these funds, they are more expensive than your average ETF. You need to watch the expense ratio and do some cost-comparison before buying.
Critics also point out that ETFs have had very low expenses and that has been their big selling point. But with actively managed ETFs, it will most likely not be possible to keep expenses at rock-bottom levels because of the increased management expertise required in running the fund. Whether this is true or not is still up in the air, but active ETFs are cheaper than mutual funds and offer more flexibility at this cost.
- Transparency? This is an issue that’s still in flux. Although active ETFs are transparent right now, some providers are pushing to offer such ETFs that won’t let investors see every move that’s made within the fund.
Current regulations require active ETFs to provide daily disclosure of holdings with a one-day lag. This means that any active manager using a unique investment strategy will be forced to reveal their strategies to the wider public, which could lead to other managers imitating the change in holdings.
Transparency is a large concern for money managers. If holdings are revealed, the worry is that investors would use the information to create their own portfolios based off of the money manager’s designs without paying for the strategy, which becomes a major concern when dealing with the money at the professional level. Competing firms could potentially steal a portfolio strategy to their own advantage, trading against a fund provider for a profit, an act known as “front-running.”
Additionally, problems involving arbitrage may occur over transparency issues. ETFs are bought and sold on the open market or the shares may be returned to a firm that created the ETF in exchange for the underlying security. If the price of the ETF doesn’t match the price of the underlying holdings, professional investors trade “creation units” to help reduce the discrepancies. However, if the actively managed ETF doesn’t disclose the underlying holdings, arbitrage does not occur and the ETF could trade at a large premium or discount to the value of the underlying holdings.
Making the Choice
There are a number of ways to incorporate actively managed ETFs into your clients’ portfolios. They can be the foundation of your strategy or complementary to your existing one or even part of a whole new all-ETF strategy.
If you make the decision to incorporate these tools, consider the points above, make sure that they add value and keep in mind that this segment of the ETF space is still growing and that we could be seeing some changes to it in the coming months and years.