Actively Managed ETFs

To date, we have focussed on passively managed exchange traded funds (ETFs).

But ETFs may also be actively managed.

Quite a new development, but some investors consider them a sexy investment.

You can decide by the end of this post how attractive they are for your portfolio.

Actively Managed ETFs

The first actively managed ETFs only came into existence in 2007. You might read elsewhere 2008. That is because the initial ETF from 2007 failed.

According to the 2010 Investment Company Fact Book, at the end of 2009 there were only 22 actively managed ETFs with assets of USD 1 billion.

Compare this with a total of 797 ETFs containing assets of USD 777 billion. So not many to choose from and very little in the way of assets.

But as they are being hyped, we will spend a bit of time on this category of ETF.

Like actively managed open-ended mutual funds, these ETFs have a management team making decisions on portfolio holdings.

As with passive ETFs, there should be a benchmark index targeted by the active ETF. However, the active managers have significant leeway in which to choose specific investments. Managers may engage in market-timing activities, alter sector allocations, or even select investments that are outside the scope of the tracking benchmark.

In a passive ETF, investors have a good idea as to the ETF portfolio. In an active ETF, the actual portfolio may deviate significantly from the target benchmark.

Advantages of Actively Managed ETFs

There are a few perceived advantages of actively managed ETFs versus both actively managed open-ended mutual funds and passively managed ETFs.

Same ETF Advantages Over Mutual Funds

The potential advantages over actively managed open-ended mutual funds mirror the general perceived advantages of ETFs over funds.

The absence of loads or sales charges; the ability to buy and sell continuously during exchange trading hours; (normally) increased liquidity; generally lower total expense ratios; possible tax efficiencies depending on jurisdiction.

Please review previous posts for more detailed information on ETF advantages relating to trading abilities and investment costs.

Improved Transparency

Another major perceived advantage is increased transparency.

In investing, transparency is the level and availability of relevant information in order for investors to make informed investment decisions. It also refers to the timeliness of  the information as data must be timely to have any relevance.

In most countries, mutual funds are required to disclose their holdings periodically. This may be quarterly, semi-annually, and/or annually.

What is held between reporting dates may be difficult to discern.

Exacerbating matters is that there is also usually a lag between period end and disclosure dates to shareholders. For example, there may be a requirement that the fund reports to its shareholders no later than 60 days from period end. That makes funds in many locations less than transparent as to their holdings.

Lack of transparency may cause problems for investors in creating efficient portfolios.

It also promotes activities by fund managers that are potentially detrimental to investors. These include window dressing, index hugging, and investment style departures.

With actively managed ETFs, transparency is greatly improved.

In many jurisdictions, actively managed ETFs must disclose their holdings on a daily basis or better. As a result, shareholders know what their investments contain and can better allocate their capital.

Active Over Passive

A potential advantage of actively managed ETFs is that they are actively managed.

While the data generally indicates otherwise, there are many investors who believe that active management can create superior returns (that is, manager alpha).

If you are in this group of investors, these ETFs may be of interest.

Costs May Be Less

One reason actively managed portfolios tend to underperform passively managed ones over the long run is operating costs.

Actively managed portfolios have management fees. They also normally have higher turnover which increases transaction and administration expenses. The greater total expense ratios in managed portfolios put them at a performance disadvantage to passive portfolios.

But while an actively managed ETF will have higher costs than a passive ETF or index fund, it may have a lower cost structure than many actively managed open-end mutual funds.

Mutual fund costs include sales distribution fees, shareholder processing and communication costs, etc. that are not present in ETFs. So it is possible that an actively managed ETF may have a lower cost ratio than a similar open-end fund.

Also, with a lower cost structure, there is less of an initial performance disadvantage against passive ETFs. So the managers have less of a hurdle to match the passive ETF results.

These factors may lead to relatively higher returns in the actively managed ETF.

Lots of mights and mays.

The reason is that actively managed ETFs are such a recent phenomenon. With only a 3 year history and so few ETFs, it is impossible to intelligently assess relative performance.

My instinct says that over time passive ETFs will prove superior in most market segments. But I shall keep an open mind until the data is in.

Disadvantages of Actively Managed ETFs

As with any investment, there are also some potential negatives.

Passive Over Active

The obvious disadvantage is the classic active versus passive argument. Why pay management fees for something that likely will not result in a positive alpha?

As we just saw, there is no evidence that an actively managed ETF will outperform over time. Until I see conclusive evidence, it might be better to stick to a low cost passive approach.

Costs May Be Less, But…

While actively managed ETFs may have less overall expenses than active mutual funds, there may be transaction costs on ETF trades that do not exist for open-end funds. Depending on one’s trading pattern, there may not be a cost advantage for ETFs over open-end funds.

Also, there can be a substantial variance between total expense ratios of ETFs and mutual funds. And this is especially true for ETFs and funds that follow different investment styles.

Always compare cost structures between investments of the same style. Never assume an ETF will automatically be less costly than an open-end mutual fund.

Improved Transparency

Another potential disadvantage is the increased transparency. Yes it is a two-edged sword.

Investors like the increased portfolio transparency. ETF managers less so.

Active managers do not like disclosing their holdings. In doing so, others can determine the manager’s investment choices and strategies and replicate them.

Many investors try to mirror the investments of successful investors like Warren Buffet. By knowing an actively managed ETF’s holdings in real-time, investors can create their own identical portfolios without incurring any management fees.

Not a profitable situation for the ETF manager.

Further, there may be pricing issues when ETF managers attempt to adjust their portfolios.

The Buffets of the world have some protection as there are delays between trades and regulatory disclosures. If they had to disclose in real-time, other investors would compete for the same investments (almost) simultaneously. This form of front running impacts supply and demand for investments and may cause significant price fluctuations for ETF managers trying to buy or sell portfolio holdings.

A potential result of this transparency problem is that the vast majority of actively managed ETFs concentrate on currencies and fixed income investments. Areas where knowing the manager’s holdings is less of a problem for future transactions and pricing.

Style Drift May Cause Inefficient Portfolios

Finally, there can be substantial style drift in an actively managed ETF.

While there may be a benchmark index associated with the ETF, managers have significant leeway to deviate from the benchmark. Without closely monitoring the ETF’s holdings, individual investors may find that their own investment portfolio has become inefficient. That is, your expected returns may be too low for the level of risk assumed or vice-versa.

Also, there may be less than efficient portfolio diversification based on investments made within the ETF.

So be careful in monitoring an ETFs actual investments versus its stated benchmark.

Conclusion

It will take a few years to assess the relative performance of actively managed ETFs.

I would suggest that you avoid being part of the test phase. Wait until the data is in before deciding if you want to invest in these ETFs.

If you cannot wait, no problem.

Just make sure you do your due diligence on any ETF you want to purchase. While there may be no track record for the ETF, review the experience and performance of the ETF managers in their previous positions. While the past is no guarantee of the future, it might provide some clues on the manager.

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