Let’s Talk About Active ETFs

Calling all asset managers!  Are you thinking about ETFs?  You should be!  Do you have an ETF strategy?  You need one!  Why is that, you may ask?  The answer is not immediately obvious.  It’s not because of recent active manager performance woes relative to their passive counterparts nor the less than ideal sales trends in certain active asset class categories.  It’s not the active v. passive debate!

Let’s make this clear, I’m not going the route of advocating for or promoting the value of index investing over active investing.  In fact, I’m not going to discuss the merits of passive and active investing in any great detail.  Yes, there are some bad actively managed portfolios.  Yes, some indexed strategies have concentrated and unwanted risks.  A prudent portfolio construction approach will take care of the active and/or passive choice for each allocation in a portfolio.  I believe there is a place for both active and passive strategies in an investor’s portfolios so let’s try to agree that there are good products in both categories.   

A recent research brief from Cambridge Associates titled “Revisiting Active US Equity Management: A Cyclical Story” eloquently discusses how performance is a symptom of movements in cyclical favoritism between investing styles in various market environments. The main point is that different strategies work better in different markets so the thoughtful combination of passive and active allocations is a prudent strategy for long-term investors. The active v. passive debate ends here (at least in this blog post)! 

It’s not one or the other – active and passive funds both have their merits.

Why Fund Managers Need an ETF Strategy

So if it’s not active v. passive, why do actively managed mutual fund managers need an ETF strategy?  Quite simply – it’s good for investors!  ETFs can greatly reduce certain costs and fees embedded within mutual funds.  This is not a blog on the mechanics of ETFs so I will not get into great detail great here, although I need to briefly mention how ETFs can reduce total portfolio expenses.  ETFs can reduce fees/costs in four important areas:

1. Reduction of fund administration and TA fees
2. Reduction of cash drag on portfolio returns
3. Reduction of portfolio trading cost
4. Ability to reduce embedded capital gain tax liabilities through in-kind trading

Let’s be frank, these fees/costs hurt investor returns.  On a compounded basis that can add up to a lot of money missing from an investor’s account just because of fees.  If the ETF structure can reduce total expenses – no matter how large or small – and efficiently deliver an investment strategy, wouldn’t that be in the best interest of an investor?  I think it would!  I should mention total expense savings of an ETF versus a mutual fund will vary by asset class and investment strategy so cost savings will not be universal for all asset classes.  Nonetheless, even a marginal reduction of expenses is still good for investors. 

The Issue of Transparency

The requirement for transparency of portfolio holdings of actively managed ETFs has prevented many brand name and talented active managers from entering the ETF market.  I would lean towards agreeing that the transparency of holdings would not be in the best interest of investors as the potential returns could be impacted by front-running or copycat trading activities . So in some cases an active ETF would not be a suitable investment for investors – at least not in their current form. 

If the transparency issue was resolved, asset managers could avoid those threats and take advantage of the other benefits of the ETF structure.  Two firms have attempted to do this.  One firm, Navigate Fund Solutions, a subsidiary of Eaton Vance, has received SEC approval to develop and launch Exchange Traded Managed Fund (branded as NextShares).  The other firm, Precidian Investments, has filed for a non-transparent ETF vehicle branded as ActiveShares.  They are still in the comment period and are working closely with the SEC on resolving certain elements of concern. 

Keeping Your Investor’s Best Interest in Mind

Regardless of the current approval status, both of these vehicles offer asset managers the potential to present and deliver a better outcome and experience to their investors.  If asset managers are serious about acting in a Fiduciary capacity for their investors and want to act in their best interest of their shareholders, they need to seriously consider if one of these or another vehicle will help them in meeting that standard. 

It’s not about active v. passive.  Investors will lean towards one or the other depending on their investment philosophy and their belief in the advantages/disadvantages of both styles.  Much of that cannot be controlled or influenced by an asset management firm.  What can be controlled by asset managers is how their product is delivered.   

Source: www.wealthmanagement.com

Source: www.wealthmanagement.com

Current and potential shareholders have all sorts of needs, demands and objectives.  Mutual funds may address those more effectively and be completely suitable for some and not for others.  The same can be said for ETFs. Mutual funds and their associated features work better within some types of investment programs and platforms.  This is also the same for ETFs.  Some investment strategies and asset classes are better managed in a mutual fund.  Again, the same can said of ETFs.  So why is there so much talk about mutual funds v. ETFs?   Asset managers need to stop being so connected to one type of vehicle and need to ascertain – if in some cases – there is a better option for their shareholders. 

This will be the first of a series of blogs I’ll write on important ETF considerations.  The following blogs will focus on more strategic and tactical elements of building a solid ETF strategy and, of course, the state of the active ETF market. 

Call me or email me with your thoughts and comments.  I look forward to an engaging conversation! 


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