Understanding Active ETFs

In previous blog posts we’ve discussed at some length a number of trends relating to ETFs and their impact on today’s fund management landscape. The increased interest of institutional investors, combined with an already strong retail uptake, has helped ETFs to grow further in popularity during the first few months of the year. In recent weeks, a number of large players known more for their active management, including Fidelity, Pimco and Eaton Vance, have launched or are planning to launch active ETF funds.

A quick recap:

  • Assets Under Management in ETF form now stand at over $2 trillion dollars, representing a ten-fold growth over the last decade. In terms of equity, ETFs make up around 25% of mutual fund size, and up to 30% of all daily trading volume on US exchanges. Turnover of actively managed mutual funds is on average 10x that of passive funds.

  • Perhaps surprisingly to some, active managers are amongst some of the largest users of ETFs, utilising them for hedging, cash management and to achieve ‘instant’ exposure to sectors and geographies in which they are underweight, or lack sufficient stock picking expertise.

  • ETFs are still very US equity-centric, with 56% of the global total focused on broad US coverage and roughly 20% US sector-focused, with only about 17% covering global equities.

  • The number and scope of Emerging Market ETFs has also expanded over the last three years, despite volatility and recent outflows. In the first quarter of this year, Emerging market equity ETFs saw hefty redemptions of $12.6bn in the first quarter amid concerns that any further rise in the US dollar will hurt future returns. The largest two are Vanguard Emerging Markets ETF and iShares MSCI Emerging Markets Index Fund.

  • There is a direct correlation between market volatility (as measured by the VIX index) and ETFs as a percentage of total trading volume.

  • The growth of the ETF industry has given birth to new products and investment strategies, as well as a new set of industry jargon, including Actively Managed ETFs, Smart Beta and Robo Advisors.

Actively Managed ETFs

The easiest way to think about active ETFs is as mutual funds wrapped in an ETF structure, allowing investors to trade intra-day and pay lower fees. There are approximately 125 actively managed ETFs (with AUM of $19bn), with the majority focused on fixed income and macro asset classes. There are 45 global (i.e. non-US) active ETFs. The numbers are still fairly low, relatively speaking, and advisors are questioning whether it’s the wrapper, the fees, or the performance of the ETFs themselves which are most to blame.

Active ETFs are designed to offer investors the benefits of ETFs, which include continuous trading, a low expense ratio and a number of tax advantages, while adding an active management component. The goal of an active ETF is to outperform its index.

One of the key differences between mutual funds and active ETFs is transparency. Unlike mutual funds, active ETFs are required to reveal their holdings on a daily basis.

This has been a concern to traditional equity managers, who prefer to keep their buying and selling intentions shielded from Wall Street traders. Publicising trades to the market can allow other market participants to front-run trades and erode returns.

The SEC is considering whether or not to allow actively managed ETFs to keep their trading secret, and has already allowed Eaton Vance to launch a series of non-transparent products that will mirror the firm’s mutual funds. Additional structures are proposed in the market which we will cover on another occasion.

Another key difference is the flexibility of the product and ability to hedge. Active ETFs can be traded at any point in the day, mutual funds only at the close. ETFs also offer investors additional ways to generate yield, returns and hedge. For example, unlike mutual funds, ETFs allow investors to short shares, buy on margin, lend and include options such as buying calls or puts.

Active ETF fees are higher than for traditional ETFs, but still lower than for mutual funds. This is because many mutual funds have distribution and service fees, and transfer agency fees, as well as trading costs associated with inflow/outflows. Active ETFs may also continue to put pressure on active mutual fund fees going forward.

Top 15 actively managed US ETFs with over $100m in Assets

While actively managed ETFs present some new challenges for the market, they undoubtedly offer new opportunities for diversified investment. For IR teams it is a space worth carefully observing.

Sources: Institutional Investor, Goldman Sachs Research, ETF.com