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.

 

mutual fund and ETF fund flows

away from active management…

There’s a long-term movement by investors of all stripes away from actively managed mutual funds into index funds and ETFs.  As Morningstar has recently reported, such switching has reached 2008-era levels in recent months.  Surges like this have been the norm during periods of uncertainty.

The mantra of index proponents has long been that investors can’t control performance, but they can control costs.  Therefore, all other things being more or less equal, investors should look for, and buy, the lowest-cost alternative in each category they’re interested in.  That’s virtually always an index fund or an ETF.

Active managers haven’t helped themselves by generally underperforming index products before their (higher) fees.

…but net stock inflows

What I find interesting and encouraging is that stock products overall are receiving net inflows–meaning that the inflows to passive products are higher than the outflows from active ones.

why today is different

Having been an active manager and having generally outperformed, neither of these negative factors for active managers bothered me particularly during my investing career.  One thing has changed in the current environment, though, to the detriment of all active management.

It’s something no one is talking about that I’m aware of.  But it’s a crucial part of the argument in favor of passive investing, in my opinion.

what is an acceptable net return?

It’s the change in investor expectations about what constitutes an acceptable net return.

If we go back to early 2000, the 10-year Treasury bond yield was about 6.5%, and a one-year CD yielded 5.5%.  US stocks had just concluded a second decade of double-digit average annual returns.  So whether your annual net return from bonds was 5.5% or 5.0%, or whether your net return from stocks was 12% or 11%, may not have made that much difference to you.  So you wouldn’t look at costs so critically.

Today, however, the epic decline in interest rates/inflation that fueled a good portion of that strong investment performance is over.  The 10-year Treasury now yields 1.6%.  Expectations for annual stock market returns probably exceed 5%, but are certainly below 10%.  The actual returns on stocks over the past two years have totalled around 12%, or 6% each year.

rising focus on cost control

In the current environment, cost control is a much bigger deal.  If I could have gotten a net return of 6% on an S&P 500 ETF in 2014 and 2015, for example, but have a 4% net from an actively managed mutual fund (half the shortfall due to fees, half to underperformance) that’s a third of my potential return gone.

It seems to me that so long as inflation remains contained–and I can see no reason to think otherwise–we’ll be in the current situation.  Unless/until active managers reduce fees substantially, switching to passive products will likely continue unabated.  And in an environment of falling fees and shrinking assets under management making needed improvements in investment performance will be that much more difficult.

 

mutual funds/ETFs in time of stress

As I mentioned last week, since the Brexit vote some property-based mutual funds trading in the UK have had to suspend redemptions while they attempt to raise the needed cash through asset sales.  This raises the question about how US mutual funds and ETFs might fare in a similar time of stress.

We have, of course, the large downturn of 2008-09 as a recent example.  The US survived that period of significant stress with scarcely any issues.  T

he worst experience of my working career, in terms of redemptions was in the aftermath of Black Monday in 1987, when the US stock market lost almost a quarter of its value in one day.  In the load fund I was running at the time, which also had a strong record, I lost about 5% of my assets under management over a few weeks.  Colleagues running no-load funds at other firms lost up to a third of theirs.  Again no very serious issues that would have required suspending redemptions.

The entire US stock market was closed for several days following 9/11.  But that was because US trade-clearing banks had their recordkeeping computers, including backups, all located in or around the World Trade Center; it took them several days to get back on their feet.  The banks have since established backup systems at more remote locations, so that presumably won’t be problem again.

It may be, then, that our potential worry is only about specialized funds that hold highly illiquid assets like property.

One significant source of regulatory worry has been the rapid growth since 2009 of passive products–ETFs and index mutual funds, which don’t have large staffs of portfolio managers and traders used to making lots of transactions.

Experience with ETFs has been, to my mind, surprisingly positive from a redemption point of view.  That’s because the theoretical idea that the brokerage houses that trade ETFs would move their bids to such a low price that all desire to panic-trade would evaporate, has so far worked every well in practice.

The only thing we as investors should note is that during several “flash crashes,”  the brokerage bid price for affected ETFs that I’ve seen has been as much as 15% below net asset value.  That’s a clear warning not to use market orders for these vehicles in bad times–or not to sell them at all.

To my mind, the one unanswered question is how liquid index funds might be in a future crisis.  The worst that happens, I think, is that big indexers do the same thing as the UK property funds and suspend redemptions for a time.  On the other hand, my entire working experience is that it’s institutions, not individuals, who panic during crises.  And these tend to cash in actively-managed products in times of stress, not index funds.  So maybe they’re not a big worry after all.

Something to think about and plan for, though.

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.

 

junk bond ETFs underperforming in a down market: it’s the nature of the beast

ETFs

ETFs are a great innovation, in my view.  Legally, they’re set up as investment corporations, like mutual funds (read my posts on ETFs vs. mutual funds for more details).  But, unlike mutual funds, which process buys and sells in-house (and charge a recurring fee to holders for doing so), ETFs outsource this market-making function to Wall Street brokerage firms.

This difference has several consequences:

–no recurring fee, so lower overall fund expenses,

–you can buy and sell all through the trading day, instead of selling at closing net asset value,

–unlike a mutual fund, an ETF holder has no guarantee he can transact at NAV, and

–you pay the broker a commission and a bid-asked spread when you transact (the second is an “invisible” cost that may offset the advantage of lower fund fees).

If you’re a buy-and-hold investor (the wisest course for you and me, in my opinion), ETFs have it all over index funds, especially for very liquid products like an S&P 500 index.

what about junk bond ETFs?

Why, then, have junk bond index ETFs been seriously underperforming their benchmarks during the current period of rising interest rates?

Several obvious factors:

–junk bonds aren’t particularly liquid.  Many don’t trade every day.  In fact, junk bond fund and ETF managers employ independent pricing services, which estimate the value of bonds that haven’t traded that day, in order to calculate daily NAV.

This means that if redemptions come, a junk bond index fund/ETF has to go hunting for buyers and won’t get the best prices for the bonds it’s selling.  The sharper-than-benchmark falls in ETF NAVs suggests they’re taking big haircuts on the positions they’re liquidating.

–ETFs attract short-term traders, who are more prone to redeem

–ETFs can be sold short, adding to downward  pressure

–ETFs don’t accept dribs and drabs of redeemed shares from the investment banks it uses as middlemen.  Brokers hold until they have minimum exchangeable quantities.  While they’re waiting, they may hedge their positions–meaning they may short the ETF, too.

Ouch!

One not-so-obvious one:

Unlike a mutual fund, the broker you’re buying and selling through has no obligation to transact for you in an ETF at NAV.  Quite the opposite.  Your expectation should be that the broker will make a profit through his bid-asked spread.

The broker typically has a very good idea what NAV is on a minute-to-minute basis.  Individuals like us usually don’t.  NOt a great bargaining position to be in.

In addition, in contrast with an S&P 500 index fund, where the broker gets an up-to-date NAV every 15 seconds, no one knows precisely what a junk bond fund NAV is at any given time (certainly the broker has a better idea than you and me, but that’s another issue).  This uncertainty makes the broker widen his spread.

On top of that, when a broker is taking on more inventory of shares than he feels comfortable with, he’ll widen his spread further, to discourage potential sellers from transacting.

Brokers know how much money they make through these spreads.  No one else does.  We do know, though, that in past times of stress the last trade of the day in a less-liquid ETFs has often been substantially below NAV.  My guess is that recent junk bond ETF sellers have paid a hefty price through the bid-asked spread to get their transactions done.  If you’re one, compare your selling price with that’s day’s NAV and see.