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Not everything in life is binary. That’s not a mantra from the culture wars but a statement of fact from the front line of the key struggle in the world of investing: the battle between passive and active funds.
Most passive funds are structured as exchange traded funds (ETFs) but there’s also a growing cohort of so-called “active ETFs”.
Some might proclaim that this surely this goes against the whole concept of passive funds — which find a big, diverse, benchmark index and then copy it by tracking its constituents. Passively.
For passive evangelists, such as the late Jack Bogle, founder of Vanguard, the whole idea was to do away with the risks and costs of an active fund manager and “buy the market” cheaply in a diversified way.
Active ETFs do follow a benchmark, but the managers then try to beat that index by tilting or fine-tuning the stock or bond selection, while also disclosing their portfolio (and returns) on a daily basis. At this point you might wonder what the difference is between an active ETF and an active listed fund, otherwise known as an investment trust (or closed end fund). It’s a good question and one many big fund managers as well as a growing number of investment advisers ask.
Like investment trusts, active ETFs trade on exchanges, but they are open-ended and their liquidity is carefully managed, which means a discount (or premium) should be marginal or non-existent. This is because shares can be redeemed on a daily basis for the underlying constituents in the fund by authorised participants.
That’s very different from an investment trust, where discounts on net asset values of over 20 per cent are now common — much to the annoyance of investors who bought the investment trust at issue or at par (or more if they bought at a premium).
Fees on active ETFs also tend to be much lower than with most investment trusts. Most charge 0.5 per cent a year or less, well below the average for equity-based investment trusts. With lower fees, next to no discounts and easy trading on exchange, it’s easy to see why many investors like active ETFs.
What’s more, the bad news for enthusiasts of investment trusts (me included) is that there have been almost no new trusts launched in more than 18 months, whereas there have been dozens of passive and active ETFs issued. That wouldn’t necessarily be a problem, but the yawning discounts on nearly all trusts has severely impacted returns.
And if the US is anything to go by — and it usually sets the lead — there are many more active ETFs coming our way.
The big fund management groups are firmly behind the idea. JPMorgan switched a number of its big mutual funds (the US version of UK unit trusts) to active ETFs. It has the biggest in the US, JPMorgan Equity Premium Income, which boasts $28bn in assets under management. Dimensional — widely used by US advisers — also switched over lots of its mutual funds and Ark Invest (run by Cathie Wood) boasts a small legion of actively managed tech equity ETFs.
Active ETFs have already arrived in Europe, though their profile is quite low. The last time I looked I counted 72 active ETFs in Europe (including the UK). Institutional investors are getting behind them as well. According to a survey by Brown Brothers Harriman, an investment bank, 32 per cent of European investors plan to increase their allocation to active ETFs this year. Even Vanguard has an interest in this area, a real breakthrough considering it has traditionally been the biggest proponent of “keeping it simple”, using passive index funds.
Most active ETFs are concentrated in ESG investing and fixed income or bonds. Active bond ETFs comprise the largest number of funds, with 47 per cent of active Ucits ETF assets in Europe aligned to fixed income strategies. Given the broader revival of interest in fixed income among retail investors, it’s not surprising that the really big fund managers are sniffing an opportunity. Axa IM, for instance, which until recently had stayed firmly away from ETFs, has launched a corporate bond tracker tilted towards ESG factors, with a low expense ratio.
Bond giant Pimco still runs the biggest active ETF in Europe. In 2011 it launched a fund called the US Dollar Short Maturity Ucits ETF which has a ticker MINT and a total expense ratio of 0.35 per cent. Short maturity hints at a common theme of these investments: in fixed income there are so many specialist markets, especially around bonds due to mature fairly soon, in which an active tilt can add real value.
This reflects an important issue. There are a vanishingly small number of fixed income investment trusts and having an active manager grapple with these tilts in an active ETF is a real advantage, particularly if the ETF is cheaper than conventional unit trusts. My own favourite fund in this space is from JPMorgan and is called the GBP Ultra-Short Income Ucits ETF, with a yield of maturity of 5.32 per cent. It actively invests in high quality, short-dated bonds and provides a kind of money market-plus return, where investors want a little extra return than cash by taking on some market risk but with relatively low volatility.
Active ETFs have also proved hugely popular in the world of ESG-infused equity trackers. Again, JPMorgan is big in this market, having launched a range of eight funds under the badge of the Research Enhanced Index Equity ESG ETF range. But it has plenty of competition. Fidelity has a range of funds and smaller outfits are frequently launching them. Another industry survey, this time from TrackInsight’s 2023 survey, revealed nearly 70 per cent of ETF buyers said they use active ETFs to access ESG strategies, either purely active or in combination with passive. Only 32 per cent solely use passive ETFs for ESG investing.
I would go so far as to say that if you’re keen on ESG and ETFs, an active fund is probably essential. You need a manager looking at the various ESG metrics to ensure the various data points used by ESG screening systems don’t churn out gibberish stock ideas. Not that I would invest in an ESG fund anyway, but that’s for another day.
As for fixed income ETFs in the short duration market, where fees must be tight because returns are likely to be at the lower end, active ETFs really make sense, as they do in green or ESG bonds. This is for the same reason as for ESG equities: poor data inputs produce bad portfolio outputs.
So what should investors watch out for when it comes to these newfangled active ETFs? Jamie Gordon, an industry expert at ETF Stream, makes a great point when he says “active managers face the same underperformance risks in the ETF wrapper as they do in mutual funds. As with all ETFs, active ETFs can also only capture listed securities, so they lose out on the unlisted exposure diversification that other structures can offer”. Investment trusts by contrast can offer that exposure but at the price of those annoying discounts.
I’d make one last observation. If the drought in new investment trust IPOs continues, I wouldn’t be surprised to see more fund managers abandoning the investment trust space altogether and launching active equity ETFs. It can surely be only a matter of months before someone comes up with an active tech equities ETF (a little like Ark Invest in the US) which might rival hugely popular UK investment trusts such as Scottish Mortgage or Polar Cap Technology.