actively managed ETFs?

ETFs vs mutual funds

ETFs are just like mutual funds, with two exceptions:

–investors buy and sell mutual fund shares directly with the fund itself.  All transactions take place at net asset value, without commission, once a day, after the close of trading. (Load mutual funds will be subject to a bid-asked spread, as well.)  The (high) costs of maintaining this sales and record keeping organization are borne by fund shareholders.

–ETFs, on the other hand, use the (much cheaper) already existing sales and record keeping system maintained by the brokerage community to record transactions in individual securities.  This allows ETFs to trade continuously throughout the market day.  Buyers and sellers pay a commission when they trade ETFs, and they also pay a bid-asked spread.  (I know of no reliable source that calculates these spreads.  The only information that ETF managers provide is a comparison of the last trade of the day with NAV calculated after the close.  This, of course, tells us nothing about what happens during the day.)  For a buy-and-hold investor, though, I think there’s no question but that ETFs are cheaper than mutual funds.

One other feature of ETFs:  brokers authorized by the ETF actually assemble themselves the securities that are in an ETF.  They only transact with the ETF manager when their holding reach a certain size, say, 50,000 shares.  This is another way to keep costs down.  But it also means that the broker has to know, every day, what’s inside a given ETF.  So the SEC requires ETFs to disclose their portfolio holdings and structure once daily.  This contrasts with mutual funds, which disclose holdings once every three months, shortly after the end of their quarter.

active ETFs

The daily disclosure requirement poses a huge problem for active management firms controlling large amounts of assets.  Their ability to outperform their peers depends (in their minds–and marketing materials, anyway) on having different (and better) portfolio composition than their rivals.  This can mean having different weightings in stocks everyone holds.  But it more often means identifying and buying a securities with favorable characteristics before anyone else, or getting rid of dog that the consensus thinks are stars.

The most attractive actively managed ETFs for most investors, I think, would be clones of existing mutual funds that have favorable long-term records.  For portfolios like these, however, it can take at least several days–and maybe weeks–to add or subtract a holding.  So secrecy is very important.  Once the name is known, brokers will frontrun the asset manager’s trading; rivals can quickly imitate its actions.  Therefore, any competitive advantage an asset manager may have from proprietary research is lost.

According to the Financial Times, large asset management firms have been inundating the SEC recently with requests to form “opaque” actively managed ETFs, where the daily holdings disclosure requirement would be waived.  The SEC has refused them all, on the grounds that brokers would hesitate to support what would be in a sense a pig in a poke.

This doesn’t mean there won’t be actively managed ETFs.  There are already a number.  But they’ve either got to be created by small asset management firms which don’t have the size problem, or (less likely) completely novel ETFs from larger firms.


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