Special Feature

ETF Guide 2015

This web-exclusive companion to Investment Executive's ETF Guide for Financial Advisors, 2015, offers insight on helping your clients understand their choices among exchange-traded funds (ETFs). In a video, Hugh Murphy, managing director of Credo Consulting, discusses the results of a recent survey of how advisors are using ETFs. Stay tuned for more web-exclusive content.

Some actively managed ETFs strive to better their benchmarks

By Jade Hemeon | May 2015

The actively managed segment of the exchange-traded fund (ETF) market is rapidly capturing market share, and Canada is far ahead of the U.S. in this innovative category.

Figures supplied by Investor Economics Inc. of Toronto show that assets under management (AUM) for actively managed ETFs were $7.9 billion as of Dec. 31, 2014 - 10.3% of the $76.8-billion Canadian ETF market. Just two years earlier, as of Dec. 31, 2012, active ETF AUM was $3.8 billion, or 7.2% of $52.6 billion in total ETF AUM.

In the U.S., actively managed ETFs account for about US$17 billion in AUM, less than 1% of the US$2-trillion U.S. ETF market. That "flips on its head" the typical 10:1 ratio that often applies to the relationship of trends in the U.S. vs in Canada, says Howard Atkinson, president of Toronto-based Horizons ETFs Management (Canada) Inc.

"Actively managed ETFs combine the best elements of ETFs and mutual funds," says Michael Cooke, head of distribution with PowerShares Canada, a division of Invesco Canada Ltd., in Toronto. "They offer the intra-day liquidity and the low-cost structure of ETFs, along with the risk-management and alpha-generating prospects of an actively managed product."

Like active mutual fund portfolio managers, the managers of active ETF underlying portfolios have free rein to apply subjective decision-making skills in selecting and trading securities. Unlike most plain-vanilla ETFs, actively managed ETFs are not restricted to duplicating a broad market index or tied to a "smart beta" strategy that follows a customized, rules-based formula. (See page 16 for more on smart beta ETFs.)

The mandate of actively managed ETFs usually is either to beat market returns or provide some other differentiating characteristic, such as offer lower risk or higher income. The portfolio manager has the freedom to make independent decisions, and the ETF is simply the "wrapper" that contains the investment portfolio.

Actively managed ETFs require higher maintenance and are, therefore, higher in cost than the indexing strategies that launched ETFs; still, management fees typically are lower than for comparable mutual funds. For example, figures supplied by Investor Economics show the asset-weighted management expense ratio for actively managed Canadian equity-based ETFs was 74 basis points (bps) in 2014, far less than the average of 243 bps for active Canadian equity mutual funds (Series A).

One reason why active mutual fund portfolio managers have difficulty outperforming market benchmarks in the long term is relatively high management fees. "The lower fees of ETFs mean that the active manager has a lower hurdle to surmount to beat the market, relative to mutual funds," Atkinson says.

Of the 340 ETFs listed in Canada at yearend 2014, 82 were defined by Investor Economics as being actively managed ETFs. The three largest were BMO Covered Call Canadian Banks, BMO Canadian Dividend and Horizons Active Corporate Bond.

"A lot of investors equate ETFs with a passive, index-based strategy; that's where the lion's share of the assets lie," Atkinson says. "But we see a lot of opportunity on the active side."

Thanks to more lenient regulations regarding disclosure of the holdings underlying an ETF, Canada is well ahead of the U.S. in creating active ETFs. Like mutual funds, Canadian ETFs are required to disclose publicly their underlying holdings on a quarterly basis, while U.S.-based ETFs must disclose holdings daily. That daily disclosure is a deterrent to active equities portfolio managers in the U.S., who are leery of encouraging front-running and copy-cat strategies that could move stock prices and put a dent in portfolio returns.

"Equity fund managers don't want to give away their secret sauce," says Deborah Fuhr, managing partner with London, U.K.-based ETFGI LLP, an ETF research and consulting firm.

Major U.S. mutual fund companies such as FMR LLC (a.k.a. Fidelity Investments) and Pacific Investment Management Co. have jumped into the active ETF business by launching bond-based ETFs that employ the strategies of these firms' successful mutual fund portfolio managers. And many major players are poised to launch equity-based ETFs that feature the skills of their successful active equities managers should the transparency rules become less onerous.

Last autumn, U.S. regulators opened the gates a crack by allowing investment-management giant Eaton Vance Corp. to launch a new pooled product called an "exchange-traded managed fund" that is a cross between an ETF and a mutual fund. This could pave the way for more actively managed exchange-traded product offerings.

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