Entering client meetings and conference halls like conquering noblemen, the champions of the exchange traded fund industry denounced stock pickers, brokers and fund gurus for their greed.
Clutching books by Jack Bogle and William Sharpe, they warned that every dollar paid in fees was a dollar less for widowers and grandmothers. They claimed there was no such thing as a stock picker who beats the index each year.
So why not buy the index and buy it cheap, they asked?
But the worm has started to turn, as traditional active and mutual fund managers attempt to claw back lost ground by launching actively managed ETFs.
This year, for the first time, more actively managed ETFs, which buy assets without following an index, have launched in the US than index trackers. According to data providers FactSet and Ultumus, there have been 42 active ETFs listed as of June 4. This compares with just 35 index funds. Fidelity and JPMorgan are among the better-known active ETF issuers.
The shift away from tracker funds is also evident at the other end of the spectrum. In the first five months of 2020, more ETFs were closed than new ETF launches — also a first. Most of the liquidations were index-tracking funds and notes.
Actively managed ETFs are “growing very quickly” and “growing faster than some of the other available strategies”, says Elisabeth Kashner, director of ETF research at FactSet.
Growth, however, is from a low base.
The spike in active ETFs may seem like a contradiction given the role that the ETF industry has played in undermining active management. But there are commercial reasons for the shift.
Chief among them is margin erosion across the asset management industry. Thanks to declining fees, asset managers’ profit margins have taken a beating, falling from an industry median of 34 per cent in 2015 to 27 per cent in 2019, according to consultancy Casey Quirk. Weaker margins came despite the share market rising sharply in the same period. Rising markets typically support profits as fees are charged on the value of assets managed.
The “fee war” in index investing has hit both active and passive managers.
“Price competition is creating fee compression in the active space every bit as much as it is in all aspects of the passive space,” says Ms Kashner.
ETF issuers initially cheered declining fees, believing that low fees would encourage waves of investor capital away from active managers to ETFs. Their belief turned out to be correct, and for the decade following the 2008 financial crisis, the stock market richly rewarded ETF issuers and those businesses — like exchanges and market makers — in proximity to them.
The outperformance of the industry was measured — perhaps appropriately — by a product called the ETF Industry Exposure & Financial Services ETF (TETF). This product measured the performance of dozens of companies that derived revenue from the ETF industry.
But the market was upended in response to Fidelity’s decision in 2018 to list zero fee index funds. After the US asset manager elected to give away some index funds for free, the air came out of the share prices of many of those companies with close links to the ETF industry. TETF, which had struggled to gather assets, was shut as its performance deteriorated.
Active ETFs are among the margin-thickening ideas being explored, says Robin Powell, editor of The Evidence-Based Investor blog.
“You can typically charge [many] times more for an active fund than [an index] tracker,” he says, adding that a similar thirst for profit is driving fund managers’ sudden embrace of ethical and environmental investing. While ethical investing has been around for decades, many fund managers have “shown very little interest in it” until fairly recently, Mr Powell says. Ethical funds, much like active funds, usually come with higher fees.
While still early, signs suggest that more and more active ETFs will come to market. Some of them will be provided by ETF issuers — many of the big-name ETF issuers, including BlackRock, also run active funds. Others will be from mutual fund managers looking to migrate to ETFs.
For mutual fund managers looking to make the shift, the Securities and Exchange Commission last year made life easier.
The SEC has approved “models” that allow active managers to list ETFs that shield their portfolios, or are “non-transparent”.
Historically, US ETFs have been required to publish their holdings every day. For many active managers, this transparency requirement is off-putting because, they claim, their stock picks are intellectual property.
Shielding ETF portfolios, however, is not unique to active managers. Vanguard, among the foremost champions of index investing, also shields its index ETF portfolios from daily disclosure. It discloses its ETF portfolio holdings on a one-month lag, citing concerns about “predators”.
According to Simon Goulet, cofounder of Blue Tractor, a New York fund manager that has won SEC approval for active ETFs, the growth potential for new active ETFs is large as there are “trillions of dollars in actively managed mutual funds” that are unavailable as ETFs.
Mutual fund managers have watched assets “walk out the door” for years, he says, and many are assessing ETF strategies to combat this.
To that end, active managers such as JPMorgan, Gabelli, Columbia Threadneedle and Nationwide Fund Advisors have signed licence agreements with an eye to listing active ETFs. Non-transparent active ETFs from American Century and Legg Mason have already listed.
While their numbers are likely to increase, much of the hard work for active ETFs lies ahead. Success or failure will be determined by their ability to convince investors and traders to buy these funds.
Winning over traders could prove difficult. Most ETF trading is controlled by specialised investment banks called “market makers”. These market makers, sometimes called “high-frequency traders”, which include Virtu, Jane Street, Susquehanna and Flow Traders, work closely with exchanges and issuers to help ensure ETFs trade cheaply and smoothly.
Market makers strongly prefer transparency, says Anthony Martin, portfolio manager at Rize ETF, a London-based ETF issuer, as it allows them to know the exact value of an ETF at all times. Knowing an ETF’s value then allows them to trade it more easily.
“If there is significant uncertainty on the portfolio, no market maker will be willing to risk exposure on the ETF,” he says. “Market makers operate on small margins, so they require accuracy.”
The bigger question is whether active ETFs can convince investors and the evidence is mixed.
Fund inflow data — which measure what investors are buying — compiled by Ilan Israelstam, a Sydney ETF expert, show that in the first quarter of 2020 active ETFs took in $3bn of new investor money. These flows came during a period of market mayhem as coronavirus spread globally. Such inflows compare favourably to the $267bn asset bleed suffered by active mutual funds and may suggest a rosy future for active ETFs.
However, flows into active ETFs were still significantly less than the $60bn raked in by index ETFs over the same period.
According to Bruce Bond, chief executive of Innovator Capital Management, an Illinois-based ETF issuer, active managers may shy away from ETFs despite the flows and SEC’s helping hand. He says that listing such ETFs will expose underperformance.
“It’s not about disclosure . . . it’s about performance,” he says. “With ETFs, they’re very easily compared one to the other . . . [mutual funds] don’t want to be compared directly because in the back of their minds they’re wondering how much value they can actually deliver.”
How the active ETFs trend unfolds is far from clear. But it is certainly giving the evolving industry plenty to think about.
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