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March 24th, 2011 by

Active versus Passive ETFs debate – a “pseudo” dilemma

Two questions were asked of me recently “Will active ETFs succeed index ETFs?” and “Has the time for active ETFs to shine finally arrived?”. My short answer to both questions is both Yes and No! Please allow me to elaborate.

First of all, the reason index ETFs became so popular is simply that they satisfied the need and craving of many investors to have low cost index investment vehicles. The index ETFs are not going away, they are here to stay for a very, very long time. We now have an ETF replicating many and various indices, their growth was tremendous and their volumes are great, but the world can have only so many indices. We will have more, but sooner than later the growth of new index ETFs will slow down.

On the other hand, now that most investors understood the value of the ETFs, they want more. Now in what shape will this come? To answer that you have to look at what is available as alternative investment vehicle. For a typical retail investor or even a High Net Worth individual access to hedge funds is not available so you are looking to get a higher (hopefully) return than an index ETF, and typically this would be a mutual fund. Why mutual fund, well because most of the mutual funds represent a fund manager that actively manages his/her portfolio. That is all good, but they are several disadvantages that mutual funds have, such relatively high fees, lack of transparency of the portfolio, not having ability to trade during the day and not having ability to short, among others.

So this is where active ETFs come in. All of the above disadvantages of the mutual funds are eliminated by the ETFs. This makes a lot of sense because we want higher than index returns, but we want lower fees and this becomes a “positive” self-fulfilling prophecy, as lower fees will increase the return over a period of time, the longer the time period, the higher the returns. The next big growth step in ETFs is the proliferation of the active ETFs.

So the answer to the first question “Will active ETFs succeed index ETFs” is Yes because we are running out of indices to base ETFs on and the next wave of ETF growth is active ETFs, but is No as well, because the index ETFs are here to stay with us “forever” as they serve multiple investing purposes, such as staying in the market, core-satellite, diversification, passive investment opportunities and others.

Now “are we there yet”, or do we have enough active ETFs to satisfy investor demand, well absolutely not. Just think of the magnitude of the mutual funds out there (over to 7,000), as they are mostly actively managed funds, and how many actively managed ETFs are out there (less than 50), the future becomes very clear. So on one hand the active ETFs are catching everyone’s attention, including the large mutual funds companies, but they have not moved on this yet, on the other hand the number of active ETFs offered can be considered as insignificant.

The reasons mutual fund companies are sitting and waiting are twofold. First they would have to lower the fees if they would run equivalent strategies through an ETF vehicle, so we are talking about maybe 30-50% fee reduction in their incomes. Second is that the mutual fund managers would have to disclose their holdings on a daily basis and that would completely demystify any “secret sauce” a mutual fund managers claims to have. Just remember, most of the secret sauce is just sugar water, as we all well aware that over 80% of the mutual funds underperform their respective index benchmarks.

So the answer to second question “Has the time for active ETFs to shine finally arrived?” is Yes, because the pressure is building up for a massive inflow of new active ETFs, but No because the current number of active ETFs is miniscule.

In my opinion, the debate of active ETFs versus passive ETFs is really a non-issue.

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