As ETF assets grow, there is pressure to reinvent the wheel. Itâ€s natural because many investors donâ€t want just beta. They may want dividends; they may want low volatility; they may want enhanced indexing. There is, for example, now a covered-call ETF on BRIC countries.
But these add-ons come at a cost. And that cost means that ETFs are not necessarily cheaper than mutual funds—at least in the U.S. Thatâ€s what Vanguard Group strategist Joel Dickson told Barronâ€s magazine recently.
His argument rests on two factors. First, passive ETFs should be compared with index mutual funds and active ETFs should be compared with active mutual funds. Second, analysts should follow the money. Itâ€s not enough to compare the MER of the average ETF with that of the average mutual fund. Instead, the comparisons should be dollar-weighted.
It turns out that American investors are price-conscious. In the passive arena, they pay 15 basis points for index mutual funds and 30 basis points for ETFs. One reason is that some ETFs are using costlier enhanced indexes. For example, WisdomTreeâ€s Japan Hedged Equity ETF (recently spotlighted on Benzinga.com, an ETF trading site) focuses on companies whose earnings are derived from exports rather than the moribund domestic economy.
Also, while 97% of U.S. ETFs track indexes—some of consequence, some of no consequence, Dickson notes—actively managed ETFs are slightly more expensive, on a dollar-weighted basis, than actively managed mutual funds.
Of course, the U.S. marketplace is not directly comparable to Canadaâ€s. Canadian mutual funds have embedded advisor compensation. U.S. funds normally do not. Instead, itâ€s pay-to-trade with a broker—and some brokerage firms are offering free ETF trading—or else clients sign up with a Registered Investment Advisor, who also has a fiduciary obligation, on a fee-for-service basis.
That split between trade facilitation and advice is not as distinct in Canada. In the interim, however, it gives fee-based advisors a leg up on advisors who rely on embedded sales commissions.
Jack Brennan, chairman emeritus of The Vanguard Group, known for its low-cost index funds, recently echoed a common sentiment when he described actively managed ETFs as an oxymoron.
“One of the reasons you index is to take manager risk out of the equation. To put manager risk back into the equation makes no sense to me,†Brennan said at IndexUniverseâ€s InsideETFs conference in February.
Most people think of ETFs as vehicles built to track indexes passively, and for good reason. To date, thatâ€s what 96 percent of them do. Even when passively managed ETFs follow reweighted or customized indexes, once the indexâ€s rules have been established, the securities selection process is computer-driven and emotionless.
But with big-name fund sponsors like Fidelity and T. Rowe Price lining up at the Securities and Exchange Commission to get into the active space, this may be the year when the actively managed ETF segment finally takes off. Some regulatory hurdles have been cleared, including a moratorium on the use of derivatives, but others remain, such as concerns over front-running.
“The index licensing grab has largely played out,†says Luke Montgomery, an analyst at New York–based Sanford C. Bernstein & Co. As a result, he adds, “many ETF providers view active ETFs as an important new frontier for industry growth.â€
Currently, there are 1,445 ETFs in the U.S. Just 58 of them, or 4 percent, are actively managed, and they hold less than 1 percent of the industryâ€s assets — 0.86 percent, to be precise — or $12.6 billion out of $1.46 trillion, Morningstar says. Of that total, $7 billion is concentrated in two successful fixed-income ETFs from Pacific Investment Management Co.: Total Return ETF (BOND), launched last February, with $4.3 billion in assets, and Enhanced Short Maturity ETF (MINT), introduced in 2009, with $2.7 billion in assets.
So why should the time be right for the launch of more actively managed ETFs?
If actively managed ETFs can outperform their index-based counterparts, they could be of great interest to both individual and institutional investors. In fact, actively managed ETFs might be the next killer app. Compared to mutual funds, ETFs have the advantage of being publicly traded and they have a lower fee structure.
State Street Global Advisors launched its first three actively managed ETFs in April of last year and filed for six more on December 27. According to Jim Ross, the senior managing director at State Street and the head of the asset managerâ€s ETFs, “We see a strong future for active ETFs†— maybe not immediately, but as a “long-term trend.†Some strategies now in wide use among mutual funds can be ported over to the ETF side only if the ETF is actively managed, for instance, balanced strategies that combine stocks and bonds, he notes. State Street is “still exploring opportunities for passive ETFs,†he says. “We think thereâ€s still room for growth there; we donâ€t think of it as an either/or proposition.â€
AdvisorShares of Bethesda, Maryland, has 18 actively managed ETFs in the market, with the latest one a global income bond fund (MINC) launched on March 20. Most of the actively managed ETFs havenâ€t had enough time to establish a track record yet. Noah Hamman, AdvisorShares†CEO, notes that the firmâ€s first actively managed ETF — the AdvisorShares WCM/BNY Mellon Focused Growth ADR ETF (AADR), launched in July of 2010 — is approaching the three-year mark. “We believe (but canâ€t be certain) this could be the first 5-star actively managed ETF,†he says, in an email. As of March 25, it had a one-year return of 5.96 percent and a return since inception of 11.08 percent. By way of comparison, since inception, the ETF beat the BONY World Classic ADR TR USD index, which had a lower return of 7.78 percent, but the indexâ€s one-year return was higher at 7.78 percent.
But the actively managed segment still has to work out a deal with the SEC — if a deal is possible — on daily transparency. That kind of transparency is not a problem with index-based ETFs since everyone knows what they own anyway, but with actively managed ETFs, which are moving in and out of positions, transparency could expose the funds to the risk of front-running. By comparison, mutual funds can operate under the cloak of secrecy since they report their holdings quarterly, 45 days after the end of the quarter. There are different proposals that are being floated with the SEC to address the question of front-running — notably, a filing made just last week by Eaton Vance of Boston for a new type of actively managed, nontransparent ETF called an exchange-traded managed fund.
The issue of possible front-running is “not a huge issue for bond funds but definitely a major issue for equity funds,†says John Hyland, the chief investment officer at United States Commodity Funds of Alameda, California, and the chairman of the National ETF Association, in an email.
Thereâ€s no rule in place that says that ETFs have to provide daily transparency, says an industry source, who asked not to be named. But when the SEC has ruled on individual ETFs, itâ€s been “very consistent†that they must provide “full portfolio transparency, period,†to get the agencyâ€s approval, he says. “The feedback weâ€ve gotten is that theyâ€re worried about potential conflicts of interest that could favor the market maker at the expense of the ETFâ€s shareholders,†he says.
Meanwhile, the SEC recently lifted one other regulatory hurdle — a moratorium on the use of derivatives. New applicants for actively managed ETFs can now use futures, options and swaps as portfolio management tools, while ETFs that were previously instructed to refrain from using derivatives can now resume. The one exception is leveraged ETFs, which are still subject to the moratorium on new applications.
The lifting of the moratorium has had no significant impact on the volume of new applications, says Liz Osterman, the SECâ€s associate director of exemptive applications, speaking at the Practicing Law Instituteâ€s “SEC Speaks in 2013†conference in Washington, D.C. in February. “Weâ€ve only seen, I think, three new applications since December 6,†she said. Out of about 100 applications for different forms of approval now pending with her office, about one third are for new ETFs, and that “divides up about half and half†between actively and passively managed ETFs, she said. Osterman noted that the Division of Investment Management was only one part of the process since the Division of Trading and Markets also has to sign off, and “they have a lot of work to do for the actively managed ETFs. Thereâ€s no generic listing standard for them.â€
Although demand has not yet jumped, Chris Thompson of Boston-based Columbia Management believes “the active ETF space is still evolving.†Columbia acquired five active ETFs from Grail Management in 2011 and filed for 17 more last August, says Thompson, who heads up distribution, products and marketing at the fund manager. Given the time it takes to get SEC and exchange approval, “we wanted to start the process early,†he says.
“We want to make sure our investment capabilities are available across a wide range of vehicles. Different clients may prefer accessing our investment capabilities in different ways, and we want to make sure weâ€re not excluding a group,†he says. “We like to describe it as being vehicle agnostic,†he adds, noting that the active ETF line-up will complement its existing line of actively managed mutual funds and separate accounts.
“Removing one roadblock at the SEC does not mean that the road ahead is set for smooth sailing,†says the National ETF Associationâ€s Hyland. “So yes, it may mean that firms go ahead and file more prospectuses for active funds, but no, it does not mean that we will see a bumper crop of them actually hit the market. Filing a prospectus is the easy part, getting it signed off by all the different regulators/divisions is a hell of a lot harder.â€
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The debate over active management versus passive management remains, but in the end does it really matter? Both styles compliment exchange traded fund investing and when used together — they can both enhance a portfolio.
“While some trace their history to as early as 2000, most were launched in just the last five years. Looking at the market size, the Morningstar managed ETF database puts total market assets at just under $57 billion as of last September, representing 486 strategies from about 120 firms,†InvestmentNews reports.
The active ETF category is still small, but the concept of actively managed ETFs is derived from asset allocation rather than stock picking, reports Jim Kim on Fierce Finance. Active ETF managers have the ability to go outside of a targeted benchmark and enhance their strategy. The small tweaks in sector allocations can work in favor of a better return, or fall flat.
The passively managed ETF has gained much recognition and merit through performance and assets. Nicole Seghetti for The Motely Fool reports that passive investments now account for roughly 20% of total invested dollars, split nearly equally between mutual funds and ETFs, and more than 40% of institutional assets.
Robert Whiteheadâ€s “Active Versus Passive Investing†white paper noted that, “Between 1998 and 2007, more than half of them (passive funds) beat the S&P 500. … If one measures performance over the ten-year period beginning in 1997, passive management wins; move forward a year and active management comes out ahead.â€
The active versus passive debate is more media scrutiny some may claim, because both styles have proven performance track records and both styles work. In fact, within a properly diversified portfolio, both active and passive ETFs can bring something to the table. Seghetti reports that neither style can emerge a true winner that would eliminate the need for the other.
Some of the most popular active ETFs to date include the PIMCO Total Return ETF (NYSEArca: ) and the PIMCO Enhanced Short Maturity Strategy ETF (NYSEArca:Â ), with $4.6 billion and $2.7 billion in assets under management, respectively. Investors can expect a spate of new, active ETFs to pick from this year, including funds from Eaton Vance and USAA Asset Management.
“ETFs continue to grow alongside passive investing as a whole, but a breakthrough in the active equity space could unleash a new wave of product development and growth, driving assets at a greater pace than prior years,†a report from Cerulli & Associates stated.
Tisha Guerrero contributed to this article.
Noah Hamman is happy to take up the flag for the active ETF space as a whole.
“In some ways, I feel that from a marketing perspective so much of what we do is addressing the issues the industry faces as a whole,†he says.
When asked about whatâ€s happening with active ETFs now that theyâ€ve hit their five-year mark, Hamman, founder and CEO of AdvisorShares Investments, is succinct; “Theyâ€re growing.â€
“Theyâ€re experiencing triple-digit growth, just liked index-based products did in their early years,†he elaborates, “But the indexed based-products started off with a well-known index behind them, the S&P 500.â€
And while investors typically use indexed-based ETFs for trading purposes, Hamman is seeing advisors “making more dollar cost averaging –type of investments for their clients for the longer term, rather than these massive trades, so it results in a smaller ticket size.â€
So after five years since the first actively managed ETFs came to market, have they finally “arrived†as a viable product? Hamman doesnâ€t hesitate, noting the growth has resulted in more products and more assets under management than index-based ETFs had in their first five years.
“Morningstar recently wrote some commentary about how active ETF assets are really the result of PIMCOâ€s recent entry into the space, which is somewhat true,†he concedes. “They also noted that actives are coming off of a $240 billion passive space, which is also true. But people raise these comparisons that are somewhat unfair. Active ETFs are growing in the number of products offered and asset size on their own.â€
Elaborating further, he notes that active ETFs have undoubtedly benefited from the education that index ETFs provided but the groups have taken different paths in their initial asset raising. During their early inception, index-based ETFs were targeted by institutions, which are traditionally able to invest more significant amounts of capital.
Active ETFs have mostly been adopted by the retail channel through fee based financial advisors who understand the benefits of active management, but also look for the benefits of the ETF structure which include intraday liquidity, better trading (risk) control (limit orders), transparency, and a more operationally efficient structure that reduces operational expense and can be more tax efficient.
“Many people are saying, ‘weâ€ll wait for three years and see what happens from a performance standpoint,†and weâ€re combating this from a sales standpoint,†Hamman concludes. “But they no longer have to do this. The transparency active ETFs offer means clients can immediately see if managers are just window dressing or if they are really delivering performance. From a risk management perspective, they have stop loss order and things like that. So itâ€s interesting; active ETFs growing.â€
]]>And yet the small number of actively managed ETF are doing remarkably well. At least, several are starting off 2013 that way.
Take the AdvisorShares TrimTabs Float Shrink ETF (TTFS), whose market price is up seven percent on the year at this writing. The Columbia Concentrated Large Cap Value Strategy Fund (GVT) is up by more than eight percent. Huntington EcoLogical Strategy  ETF (HECO) is up by nearly eight percent. There are others turning in a better few weeks than, for instance, the SPDR S&P 500 ETF (SPY), up by nearly six percent.
Worth noting: No active stock ETF has particularly strong trading volume or large assets under management. That may not necessarily be a problem. The underlying components are usually pretty liquid. So buying in small amounts with a limit order, or talking to market makers about a bigger order, shouldnâ€t be a problem.
Who knows whether it will continue. But the big picture suggests itâ€s more likely today than last year or the year before. Ned Davis Research ETF strategist Neil Leeson argues in a note this week that the decline in asset correlation — thatâ€s the tendency of stocks and other assets to swing closely together in price — should be good news for stock pickers and for recipes other than “buy everything†indexing. Itâ€s a theme we cover frequently as it pertains to mutual funds.
As Leeson puts it:
]]>I know it is early, but as our Sector Strategists pointed out late last year, the “decline in correlations among stocks suggests company-fundamental factors are likely to have an increased influence on selection,†and the out-performance of the active funds thus far suggests that 2013 has started as a “stock-pickerâ€s†market.
McKinsey says name brands will drive big growth over next seven years
Actively managed exchange-traded funds have yet to take off with investors — with one big exception — but over the next several years, experts expect them to grow faster than their passive brethren.
Pooneh Baghai, co-leader of the Americas wealth management, asset management and retirement practice at McKinsey & Co., predicts that assets in actively managed exchange-traded funds will explode to $500 billion by 2020, up from $10 billion today.
“We think active ETFs have major momentum,†she said. “It’s not a question of if; it’s a question of when and how much.â€
Growth will be driven by big brands such as Fidelity Investments, T. Rowe Price Group Inc. and Franklin Resources Inc., Ms. Baghai said. The three firms, along with several others, are in various stages of getting approval from the Securities and Exchange Commission to launch active ETFs.
Bill Gross and his Pacific Investment Management Co. LLC showed the power a brand can have in the active-ETF business last year with the launch of the Pimco Total Return ETF (BOND). In less than a year, the ETF has grown to more than $4 billion, and in 2012, it accounted for about 80% of the overall growth of active ETFs.
Peter Quinn, president and chief operating officer at RiverFront Investment Group LLC, uses both active and passive strategies in the model portfolios his firm creates for financial advisers.
He said he could see active ETFs taking the place of a mutual funds’ institutional share class in fee-based accounts, where ETFs are most popular, especially if the expense ratios come down.
“That may drive the phenomenon,†he said.
At least one company isn’t getting too excited about active ETFs just yet. Daniel Gamba, head of iShares Americas Institutional Business, said active ETFs aren’t a priority right now for his company, which is the largest provider of ETFs at $556 billion in such assets.
“We’re taking a wait-and-see approach,†he said.
“Everybody has a point of view,†Ms. Baghai said. “We’ll know who’s right in 10 years.â€
]]>The companyâ€s proposed Active Short Duration Income ETF, its first active ETF, which will invest in investment grade short-term fixed income securities, professes to share the same goals as money funds – capital preservation and daily liquidity. It will also forego the guarantee of a stable net asset value in exchange for the potential of modest investment gains.
A spate of other fund managers have launched similar ETFs or plan to, including Federated Investors, the third-biggest money fund provider, and iShares, whose parent, BlackRock, is the fourth biggest. The most successful of such ETFs has been Pimcoâ€s Enhanced Short Maturity Strategy (better known by its ticker, Mint), which has amassed $2.2bn in assets.
The emergence of short-term ETFs coincides with a heavy gloom gripping the money fund industry. Persistently low interest rates have eaten into returns, and the Federal Reserve has promised the federal funds rate will remain “exceptionally low†at least through mid-2013.
Schwab has joined other money fund providers in waiving fees in order to prevent net asset values from slipping below the sacrosanct $1 per share level. In the first nine months of this year, such waivers cost it $445m, on top of more than $1bn over the course of 2010 and 2011.
Simultaneously, regulators are pressing for safeguards to prevent runs on money funds in the rare instance that they do dip below $1 per share, as occurred during the financial crisis. The proposed reforms, which include requiring the funds to abandon their stable net asset value policy and building up capital reserves, are liable to cost the funds business.
The short-term ETF forays suggest Schwab and others are hedging their bets on a money fund revival. Schwabâ€s filing occurred in the same week that its chief executive, Walt Bettinger, announced the company was endorsing a floating net asset value for institutional prime money funds, in a major concession to regulators.
Conspicuous in their absence from the short-term ETF market are Fidelity and JPMorgan Chase, the two biggest money fund providers. Fidelity is developing a line of ETFs but has not disclosed much about the offerings. JPMorgan, meanwhile, has filed to launch active ETFs but does not seem interested in following through. George Gatch, chief executive of the investment management Americas business at JPMorgan Asset Management, told Reuters in an interview a year ago that he does not consider active ETFs to be worthwhile for investors.
]]>A comprehensive analysis of fund returns in the UK by Vanguard has revealed that costs are the central contributing factor underlying the under-performance of active funds versus their benchmarks over the long-term.
Peter Westaway, Chief Economist at Vanguard.
According to Vanguardâ€s Case for Indexing research, only 17% of active equity funds and 4% of active fixed income funds that were in existence in 1997 outperformed their prospectus benchmark over the subsequent 15 years. The report revealed similar levels of under-performance over five- and ten-year periods.
Vanguard compared Morningstar performance data on equity funds (UK, European, Eurozone, US, Global and Emerging Markets) and fixed income funds (UK diversified bonds, UK Government bonds, Global, USD and euro diversified) to the performance of the benchmark quoted in the fundâ€s prospectus. Vanguardâ€s research found that survivor bias – the tendency for funds with poor results to be closed or merged, leading to false conclusions about overall active management performance – helped to mask the true level of under-performance.
Tom Rampulla, Managing Director of Vanguard, said: “Many investors will be disappointed by the level of under-performance across a range of active equity and bond funds. Our research illustrates just how rare it was for active funds to consistently outperform over the long term. The high costs that often go hand in hand with active fund management are a considerable drag on performance.â€
The report also highlights the difficulties in selecting the best-performing active managers based on past performance. An actively-managed UK equity fund that was ranked in the top quintile in the five years ending December 2006 was more likely to fall into the bottom quintile (23.4%) than remain in the top quintile (15.6%) five years later. Over the same time period, 60% of top-quintile funds in 2006 fell into the bottom 40% of all funds, or closed completely.
The reportâ€s co-author Peter Westaway, Chief Economist (Europe) at Vanguard, pictured, said: “These figures show the challenge facing even the most skilled professional investor looking to pick the right active manager. The research shows that there was no strong link between past and future performance. Historical data was a very poor indicator and teaches us little.â€
He added: “The data suggests that most strategies for picking outperforming active funds are likely to fail. Over each time period that we examined, only a small number of active funds outperformed. Index-tracking funds have a cost-driven tail-wind relative to the vast majority of actively managed funds, and have delivered better returns than all but a few active vehicles.â€
The report helps build on the already strong case for passive index-tracking products such as exchange-traded funds (ETFs).
]]>RIAs surveyed believe ETFs will make up 24 percent of portfolio allocations over the next 12 months and 33 percent over the next three years, representing a 10 percent increase over results reported in Invesco’s survey of RIAs in 2011.
Against a lingering backdrop of global economic uncertainty, RIAs still see clients remaining vigilant in their aversion to risk as 91 percent believe their clients are more interested in minimizing losses than maximizing gains.
“This year’s study continues to show how RIAs are embracing the value of ETFs and the many ways they can be implemented in their clients’ portfolios,” said Bobby Brooks, National Sales Director for Invesco PowerShares. “But even as the equity markets have enjoyed a strong run year-to-date, RIAs are still indicating that risk management is a primary focus and they are looking to a variety of products, including alternative assets, to manage risk.”
With such issues as portfolio allocation and risk management in mind, Invesco partnered with Cogent Research to conduct its second blinded study to learn what’s top of mind for RIAs and their clients given current market conditions.
Among other key findings in the Invesco study:
RIAs continue to blend active and passive funds in a single portfolio Forty percent of RIAs agree that now more than ever they are creating client portfolios using a blend of active investment vehicles and passive ETFs. Less than a quarter of RIAs utilize an exclusively all active management portfolio (24 percent) or an all ETF/passive management portfolio (19 percent).
Risk management remains a priority Consistent with the 2011 survey, RIAs cite managing risk as a predominant philosophy in managing client assets (40 percent). The survey showed wealth preservation as the most important issue for clients, followed by mitigating risk.
Risk management investment strategies have not changed RIAs continue to mitigate risk in client portfolios by creating a blended asset allocation of active investments and passively managed ETFs (62 percent) and applying a more conservative asset allocation (56 percent).
Alternatives, emerging market equities and large-cap funds drawing more attention Within actively managed mutual funds, RIAs are most likely to increase capital over the next 12 months in alternatives (46 percent), emerging market equities (43 percent) and U.S. large-cap funds (40 percent).
About the Invesco RIA Market Research Study The RIA Market Research Study was conducted for Invesco by Cogent Research in late August and early September 2012. The study is based on a survey of RIAs around the country with an average of $478 million in investable client assets. Cogent Research is not affiliated with nor employed by Invesco.
To address concerns RIAs have regarding risk management, the Invesco RIA Division launched nationwide “Risk Institute” seminars earlier this year. These meetings provide RIAs risk education, risk-aware implementation ideas and programs to help them effectively speak with clients about risk topics.
]]>“There is nothing novel about the index versus active debate,†the new S&P Indices Versus Active Funds Scorecard (SPIVA) report notes. “It has been a contentious subject for decades, and there are a few strong believers on both sides, with the vast majority of investors falling somewhere in between.â€
Many market watchers are saying that ETFs are posing significant headwinds for actively managed funds and the managers who run them. Morningstar data claims that of ETF and mutual fund market share, only about 12% is represented by ETFs. That means there is a lot more potential for ETFs to gain assets.
The S&P report also highlighted that passive management also wins out over the long term time frame. Most active managers fail to outperform their benchmarks over the long term, reports Rob Silverblatt for US News. [Investors Tired of Lagging Active Funds Pile Into ETFs]
The trend also repeats itself when it comes to bond funds. Take, for instance, actively managed long government bond funds. Over the past five years, 93.62 % of them trailed the Barclays Long Government index, reports Silverblatt.
The one area that is an exception now is the large-cap value fund. Over the past five years, more than 60 % of active funds in that category beat the S&P 500 Value index. Last year the gap was closed, with about 27% outperforming. [PIMCO Total Return Hits $3 Billion in Assets]
“ETF product offerings should continue to expand and gain market share,†RBC analyst Eric Berg wrote in a report released on Tuesday. “We believe that this will come at the expense of actively managed funds.†[Ongoing Shift to Fee-Based Advisor Model Supports ETFs]
The continual focus on investment fees is another boost to passive management. Active management is much more expensive than passive index tracking, and with so many ETFs offered at a low rate, investors are drawn to these vehicles. As more investors realize that fees are a drag on performance, mutual funds will remain under a certain amount of pressure.
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.
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