actively managed ETFs begin to attract investors

About 2 1/2 years ago, I first wrote about actively managed ETFs.

As I mentioned in greater detail then, for buy-and-hold investors ETFs can be substantially cheaper than mutual funds.  That’s because mutual funds maintain their own high-cost distribution and recordkeeping networks, while ETFs use the much larger, and cheaper, infrastructure maintained by Wall Street brokerage firms.  To pluck a number out of the air, the added value of the ETF route could be 50 basis points (0.5%) in annual return.

Active ETFs have never really taken off, though.  That’s partly because start-up active ETFs can be illiquid, and therefore difficult to trade.  And, again because of their small initial size, expense ratios can appear to be very high.  In addition, large mutual fund groups have been reticent to launch active ETF clones of their mutual funds.  Most firms don’t want to be pioneers.  But also, if an associated ETF begins to trigger redemptions of a mutual fund, the fund’s expense ratio will begin to rise–presumably creating more momentum to redeem.  That’s because the costs of distribution will be spread over fewer shares.

This may all be beginning to change.

As Factset reports, actively managed ETFs had large inflows for the first time ever in May.

Two things caught my eye:

–the Principal Financial Group launched an actively-managed, dividend-focused global ETF last month that took in $424 million, and

–ARK Investment Management, a small firm focused on “disruptive innovation”  received $37.3 million in new money in its flagship ARK Innovation ETF (ARKK) + the ARK Industrial Innovation ETF (ARKQ)  (Note:  I’ve owned ARKW, the firm’s internet fund, for a long time).  ARKK and ARKQ together had assets of $53.4 million at the end of April.

My first thought about the strong ARK showing was the attraction could be that the firm has been an early investor in the Bitcoin Investment Trust (GBTC).  But ARKQ doesn’t hold it.

It’s noteworthy, too, that Principal should want to cannibalize its mutual funds–although it’s always better to cannibalize yourself than to have other firms do it.

 

We may be at a positive inflection point in the development of active ETFs.  Good for innovation, if so.  Bad for stodgy mutual fund complexes, at the same time.

 

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.