The active-passive paradox

Active ETFs are gaining traction, with assets on the rise and more providers seeking to issue new funds. Yet these hybrid products are evoking mixed opinions in the industry. Matthew Craig reports

To some, the concept of an active ETF is an oxymoron on a par with controlled chaos, open secret, or alcohol-free vodka. But others see nothing contradictory in combining the virtues of an ETF with the benefits of active fund management. Perhaps the concept is an investment equivalent of marmite; some love it, while others hate it.

Before going any further, it would make sense to define what is meant by active in this context. Many ETFs passively track a market index such as the FTSE 100 or the S&P 500, but it can be argued that tracking some indices, such as those weighted according to fundamental measures of company performance, rather than market capitalisation, is a form of active management. 

Innealta Portfolio Advisors chief investment officer Jeff Buetow said an investment approach that uses accounting and finance measures in order to determine where to invest must be considered active management. “These are active bets, there’s no question about that,” said Buetow. 

But not everyone agrees with this. Invesco Perpetual head of listed fund sales Tim Mitchell said ETFs which use fundamental indexing, such as the PowerShares products, may generate alpha but are most definitely a beta strategy; they do not pick stocks, but reallocate the weightings in an index. 

BlackRock managing director and global head of ETF research and implementation strategy Deborah Fuhr said: “People have said fundamental index-tracking ETFs are active, but they are still tracking an index”. Perhaps ETFs using fundamental indexing or other quantitative techniques can be considered ‘semi-active’ investing, if that is not another oxymoron. 

The road to active management

After passive and semi-active investing, the next stage on the investment spectrum is full-blown active management, with a stock-picking fund manager trading a portfolio of stocks. Here, those against mixing ETFs and active management have several objections.  

The principal one is that true active management runs counter to the transparency of ETFs. Fuhr commented: “One challenge is that active funds don’t want you to see inside them and if you don’t have that, you don’t have the real-time indicative net asset value (NAV) of an ETF.”

Mitchell at PowerShares also raised this point, saying that a market maker for an ETF needs to know what the underlying investments are in the fund. “If you don’t have that knowledge how do you price it?” asked Mitchell.

However, it seems there may be ways around this for active ETFs. Some semi-active, fundamental index ETFs can offer full transparency because they are rules-based, according to Manooj Mistry, head of db x-trackers UK. 

While active stock-pickers might not want to operate in a fully transparent environment, Mistry said: “Pure active ETF products in the US have disclosure but it is delayed, as there is a lag of two or three days.”

Another issue is cost, as plain vanilla index ETFs are relatively inexpensive in terms of their total expense ratio (TER) and the costs of active management, including fund manager remuneration, will increase TERs. Mistry said: “Most active and semi-active ETF products will have higher costs compared to pure beta ETFs. Why should I pay 1% for a product when the passive option is a fraction of the price?”

In Europe, most users of ETFs are institutional investors and they prize ETFs for the fact they offer cheap beta, which can then be utilised for asset allocation. BNP Paribas Asset Management head of the EasyETF platform, Danièle Tohmé-Adet, said active ETFs cannot give sophisticated investors the ability to manage their risk budgets that they get from passive ETFs. She added: “Active ETFs don’t really fit with the needs of asset managers in terms of risk budgeting. They will take more of the tracking error budget.” 

It can also be argued that active ETFs do not make sense from a fund management business perspective. Invesco Perpetual’s Mitchell asked: “Why would you take a star fund manager and stick him in a format where you are giving him away at a cheaper price? You should be able to charge more for a good fund manager who can deliver alpha.”

Positive thinking

While all these arguments against active ETFs carry some force, proponents of these funds can muster a number of counter-arguments of their own. One view is that while active managers may see lower fees when they use ETFs, competition will make this inevitable. 

Magoon Capital chief executive officer Christian Magoon said: “The goal of active ETFs isn’t to take market share from passive ETFs, but to compete with active mutual funds.” With the great majority of mutual funds being actively managed, this means we can expect to see more active ETFs as the ETF market evolves.

Likewise, GreySpark Partners managing partner Frederic Ponzo believes that “the invisible hand of the market”, in the words of Adam Smith, will compel active fund managers to use lower margin ETFs. He said: “Competition forces you to become more efficient and market pressures will definitely lead this way. It will take some time but it will happen.” 

He added that larger fund management firms could use the low-cost nature of ETFs to their advantage. “This is the Wal-Mart theory; if you sell cheaply, you will sell more and in the end you will make more profits but you have to have the distribution capability to do this.” 

Recent innovation

As well as using ETFs as a weapon in the ongoing battle for market share, some experts can see benefits in wrapping an active fund in an ETF. US fund manager AdvisorShares launched what it describes as an actively managed ETF in September 2009, the Dent Tactical ETF, which implements global tactical asset allocation decisions with ETFs as its underlying instruments. 

AdvisorShares chief executive officer Noah Hamman said: “Mutual funds can only be bought and sold at the end of the day, but ETFs can be bought and sold throughout the day. They can deliver to investors what they want in a more efficient structure.” The fact that ETF prices are quoted like shares means investors can react in real-time to events, which is not possible with mutual funds.

While active management costs more than passive investing, Hamman said active ETFs will still be cheaper than active mutual funds, as operationally ETFs are less expensive to run than mutual funds. He added a disadvantage of mutual funds is that investors who trade frequently add to the overall fund’s costs which are then shared with long-term buy and hold investors. Hamman commented: “With ETFs, investors who want to be really active don’t affect long-term investors. It is a far more efficient structure for both types of investor”. 

The intra-day trading of ETFs is not seen as an insurmountable issue for supporters of active ETFs, with either some form of delay in holdings disclosure or an acceptance of greater transparency seen as solutions. ETFs are also viewed as a possible conduit for hedge fund investing strategies.

Qbasis Invest is a specialist in systematic managed futures. Co-founder Philipp Pölzl said by offering a Liechtenstein-based ETF for distribution in Austria and Germany initially, the firm can market an onshore fund to retail investors with a minimum investment of €2,000. He said this compares to a $100,000 minimum for its flagship managed futures fund, which is also an offshore product. 

Pölzl explained the ETF format proved to be a better vehicle than a Ucits fund, as the latter would have been complicated and expensive to operate. Liquidity was another advantage, particularly as managed futures strategies are normally traded on a weekly or monthly basis. In terms of market making, Pölzl commented: “In our case the market maker gives one price per day to the exchange, but if there were significant movements, it would quote a different price. Investors can trade around the price, because the market maker gives liquidity”. 

The first step

Overall, it is clear the debate over the benefits of active ETFs is only just beginning. According to Fuhr, only 22 out of 2,095 true ETFs can be considered active in some form, but this number looks set to rise. Magoon said that while there are 14 or 15 active ETFs in the US at present, this could increase to 40 or 50 by the end of this year, as large fund managers such as Pacific Investment Management Company (Pimco) and T Rowe Price enter the fray. 

The arrival of large mutual fund managers in the ETF space marks a significant development in the growth of this market, but it could take time for new actively managed ETFs to take off as investors wait for good three-year track records to be achieved. Once this happens, investment funds could flood in. 

Another factor is the changes to existing distribution practices. US managers are not including the 25 basis point trail commission found on US mutual funds on ETFs, while ETFs in Europe do not offer commission either. Regulatory initiatives such as the UK’s Retail Distribution Review could act as a powerful boost for ETFs as a commission-free product in a more fee-based environment. 

While there are strong arguments for active ETFs, it remains to be seen if they can become synonymous with a happy marriage in investment terms, rather than a curiosity. Ultimately, if ETFs really are a better investment vehicle than mutual funds and if they are capable of housing active manager strategies, then we can expect to see more active fund managers joining the ETF party over time.