Actively managed ETFs have now been in existence for several years. However, they may have advisors who are more accustomed to the mutual fund model scratching their heads, since on the surface at least, they seem nearly identical.
But there are some big differences between the two products that might help you decide whether it’s worth switching over to these ETFs from mutual funds.
It may seem contradictory to have a manager picking stocks, since until recently, ETFs have been known primarily for the fact that they passively track indexes. Proponents of active ETFs believe that both ETFs with active management and those that are passively managed are able to coexist, as they serve different needs within a portfolio.
There are also benefits to be had in actively managed ETFs that you simply can’t get with a mutual fund.
Active ETFs have lower expense ratios, better tax advantages, greater transparency and better trading flexibility. An actively managed ETF will cover a benchmark index, but managers may decide to change sector allocations, market-time trades or trade outside of the benchmark. The greater freedom given to managers makes it more difficult for investors to anticipate the future makeup of the portfolio and the strategy also produces returns that will not reflect the underlying index.
If you’re comfortable with ETF products already available but want to dabble in other investment tools, the transition from passive to active may open up a broad range of active strategies that can offer standalone strategies or matched to enhance a portfolio. Active ETFs expand the flexibility of asset allocation decisions since one is able to choose passive management, active management or both within the vast ETFs product line.
The Benefits of Active Management
Some of the major benefits you can get out of actively managed ETFs are:
- Transparency: Like index-tracking ETFs, actively managed ETFs are required to disclose their holdings daily. While this reporting may not be down to the minute, you do have access to holding information at the end of each trading day. Contrast this with mutual funds, which are only required to disclose holdings quarterly.
- Lower Cost: The average cost of a mutual fund is 1.54%. That might seem like a tiny amount, but multiply that over years and it could potentially be tens of thousands of dollars. The average actively managed ETF expense ratio is 0.61%.
- Liquidity: Active ETFs can be bought and sold like any other ETF – all day long on an exchange. Mutual funds can only be bought and sold at the end of each day.
- Benefit of Brains: Like with mutual funds, you still get the benefit of an expert who knows his or her stuff trading within the fund.
- Better Tracking of Asset Classes: Certain asset classes simply work better with the active management model, for example, bonds. An actively managed portfolio of bonds can give you exposure to the right bonds at the right time.
Actively Managed ETFs: The Next Big Thing?
Although active management in ETF form is a good idea and better serves investors than mutual funds, investors have been slow to adopt them.
But that doesn’t mean that there hasn’t been a lack of interest in actively managed ETFs if you consider the number of SEC filings that we have seen from existing ETF providers, big-name banks and even companies that are known more for their mutual funds.
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.