Analysis: Active ETFs wait for their heyday

It’s easy to see why many people have become a little enamoured of the potential of these vehicles. Active ETFs give investors an efficient way to gain access to active investing strategies that can be cheaper and more transparent than open-ended mutual funds. They’re also very tradable.

But brand-name managers have been slow to climb aboard the supposed bandwagon. Managers who run concentrated equity portfolios, for example, are not keen to show their portfolios on a daily basis. Also, some managers are reluctant to operate in a vessel with no loads or redemption fees to buffer the costs associated with asset flows. Delivering an active strategy in an ETF would also take away managers’ ability to close their funds to new investors at those times when their strategy has hit “capacity” or they don’t see ample opportunity in their traditional fishing holes. After all, an ETF that is closed to new investors would essentially be a closed-end fund.

Despite these concerns, many firms are preparing to take the plunge. In the United States there are far more firms that have filed to launch active ETFs (35) than there are current providers of such funds (15) at the moment. Most of them are fixed-income funds, and many of these are of the very short-term variety. Because bonds are traded over the counter instead of on an exchange, fixed-income managers are less concerned with other investors front-running or shadowing their portfolios. Daily transparency is not much of a concern for them.

Despite a more favourable regulatory environment than our southern neighbours, actively managed ETFs in Canada still represent a small slice of ETF assets. Daily portfolio disclosure is not required in Canada, which alleviates the front-running concern, particularly for equity strategies. Horizons AlphaPro Managed S&P/TSX 60 ETF HAX was launched in January 2009 as the first actively managed ETF in Canada, but was subsequently closed. A series of actively managed allocation strategies from BlackRock Canada’s iShares actually appeared in 2008. However, we cite the Horizons ETF as the first given that it was the first to have a portfolio manager making individual security selection decisions.

By this definition, there are about 36 actively managed ETFs (excluding advisor class shares) with roughly $2 billion in assets. Including allocation and covered call strategies takes the number up to 67 actively managed ETFs (excluding advisor class shares) with more than $6 billion in assets. Even by this more inclusive definition (which includes rules-based strategies that don’t follow an official benchmark), the segment represents less than 10% of total Canadian ETF assets. Going by the standard (and more exclusive) definition of active management, however, the group represents less than 4% of Canadian ETF assets, the overwhelming majority of which are held by Horizons AlphaPro ETFs.

In the U.S., Bear Stearns launched the first actively managed ETF in 2008. Called Bear Stearns Current Yield, it quickly closed that same year as the parent firm collapsed. Five years later, actively managed ETFs are still struggling to gain traction. As of August, there were 64 actively managed ETFs holding US$14.4 billion in assets. That represented a measly 1% of the total assets invested in exchange-traded products in the U.S. Even more telling: 60% of actively managed ETF assets are in funds run by PIMCO. Indeed, PIMCO Total Return ETF BOND alone accounts for about 30% of all active ETF assets.

Fund companies such as PIMCO have effectively used the ETF wrapper as a new means of distribution to deliver time-tested active strategies to the masses in a manner that reduces the cost of investing in them for a wide swath of investors. That’s not always the case, though. Others such as AdvisorShares Global Echo ETF GIVE seem keen to leverage the trendiness of the active ETF category as a way to market funds with unproven managers that wouldn’t likely stand a chance in a traditional mutual fund format.

The good news for investors is that it is very easy to discern among the good, the bad, and the “other” in the actively managed ETF universe as it stands today.

Looking at asset size is a good way to separate the wheat from the chaff in the current crop of active ETFs. The standard threshold for an ETF with long-term staying power in Canada is about $50 million. Only 22 out of the 67 active ETFs in Canada meet this threshold (just 11 ETFs meet the cut-off under the stricter definition outlined above).

Of the 64 active ETFs that trade in the U.S., just 18 have more than US$100 million in assets. In that country, the US$100 million figure is widely perceived to be the dividing line between a fund that is on its last legs and one that will have long-term staying power. The odds that a fund will wind down greatly increase when its asset base stagnates below $50 million in Canada and US$100 million in the U.S.

Assessing fund closure risk is important. Shuttering a fund may result in a taxable event for investors; it could be accompanied by associated costs, some of which may be borne by investors; and a liquidation will almost certainly lead to uncomfortable conversations with clients for the advisors that recommended the ETF.

The data show that investors already know this and are generally avoiding smaller funds. The 46 actively managed U.S. ETFs with less than US$100 million in assets hold just 7% of total active-ETF assets. Most of these smaller funds will likely languish and many will ultimately die on the vine. Four have closed this year and more will follow. Actively managed ETFs with less than US$100 million in assets have accounted for just 6.4% of net inflows into the category over the past 12 months.

Low costs are one of the hallmarks of the ETF wrapper. Unfortunately, that would not be immediately apparent to someone examining the current lot of active ETFs.

More than 40% of active ETFs in Canada have management-expense ratios in excess of 1% (although, those funds account for just 9% of active Canadian ETF assets). Meanwhile, the asset-weighted expense ratio of the group of active ETFs with more than $50 million in assets is just 0.70%. This is further evidence that investors have already spotted many of the weeds in this field.

It is vital that fund companies never forget what the “ET” in ETF stands for. Working with market makers to foster liquidity in their funds’ shares is a key aspect of creating a favourable investor experience. The failure to keep markets honest on the part of the fund sponsor could result in wide bid-ask spreads or persistent premiums or discounts versus the fund’s net asset value. These dislocations could result in additional costs to the end investor, costs that don’t enter the equation when dealing in traditional mutual funds.

Morningstar looked at the average liquidity levels for the current line-up of active ETFs in the U.S., breaking the group into two along the size levels mentioned above. There are clear differences. The median of the average daily trading volume among the active ETFs with more than US$100 million in assets over the trailing three months was 92,959 shares per day. This is more than 14 times the comparable figure for the group with less than US$100 million in assets. Scant liquidity is another reason why these funds will likely languish.

The pillars of the Morningstar Analyst Rating for funds are also pillars of success in the land of active ETFs. It is no coincidence the largest actively managed ETF, PIMCO Total Return, happens to be the sibling of the largest mutual fund on the planet. PIMCO Total Return, rated Gold by Morningstar’s U.S. fund analysts, has employed a rigorous process to handily best its benchmark since its inception in 1987 with Bill Gross, Morningstar’s Fixed-Income Manager of the Decade for the 2000s, at the helm.

Similarly, the remaining four funds that make up the five largest actively managed ETFs in the U.S. also have experienced specialists working behind the scenes. WisdomTree Emerging Markets Local Debt ELD and WisdomTree Asia Local Debt ALD are sub-advised by an experienced fixed-income team at Mellon Capital Management Corp. SPDR Blackstone/GSO Senior Loan ETF SRLN marks GSO/Blackstone’s first foray into a vehicle offering daily liquidity in the bank loan sector. GSO/Blackstone is one of the world’s largest loan buyers, occupying an important position in a somewhat esoteric and fairly illiquid asset class. And like its larger sibling PIMCO Total Return, PIMCO Enhanced Short Maturity ETF MINT taps into the Newport Beach, Calif.-based firm’s procedural rigour and deep bench of experienced analysts and portfolio managers.

So, while active ETFs may be the new kids on the block, the people behind the segment’s success stories have proven processes and track records that testify to their merit.

— With files from Morningstar ETF analyst John Gabriel

Ben Johnson is director of passive funds research, North America and global ETF research for Morningstar.