From the September 2011 issue of Research Magazine • Subscribe!

September 1, 2011

Time for Active ETFs?

Assessing active ETFs with AdvisorShares’ Noah Hamman.

Exchange-traded funds, having broken through the $1 trillion asset threshold, are no longer seen as esoteric products meant just for institutional investors. Rather, they’re on the map as straightforward vehicles that retail investors too can successfully use.

While index ETFs rule the roost with almost 100 percent of all ETF assets under management, actively managed ETFs are nudging for market share.

One of the most interesting differences between the mutual fund market versus ETFs is how investment dollars are being allocated. Today, the bulk of mutual fund assets are invested in active funds whereas most ETF assets are invested in index-linked products. What are the future prospects for actively managed ETFs? And how should advisors be preparing for these changes?

To address such questions, Research spoke with Noah Hamman the founder and CEO of AdvisorShares. The firm as of end-June managed $318 million across six actively managed ETFs.

What are some of the advantages and disadvantages of actively managed ETFs?

By far the biggest benefit is providing professional, discretionary portfolio management, but doing that [with] full transparency, buy and sell control (limit orders), and liquidity. Secondarily, the inherent tax advantages are better than the traditional mutual fund structure. The downside depends on what you are comparing it to, but I might say that most mutual fund investors are not use to dealing with bid-ask spreads and commissions, so incorporating that into understanding the cost of the ETF is important, though that is not unique to just active ETFs.

Active ETFs and active closed-end funds share many of the same attributes. How are they different?

The difference is premium and discounts. Because ETFs are open-ended, authorized participants (institutional who can buy and sell ETF shares in million dollar baskets), have the ability to create new shares or redeem shares at NAV, so if an active ETF were to trade too far from its estimated NAV during the day, [these] authorized participants can arbitrage the price difference, which should have the impact of moving the trading price back to its estimated NAV.

Active ETFs have been lauded for their holdings transparency, but isn’t this actually a disadvantage because of front-running?

Not at all. Front-running is someone [having the] ability to step in front of the trades a portfolio manager is making. I can see that happening to an index, for example during a Russell rebalancing. For an active strategy, you would need to guess what a portfolio manager is doing. In an active ETF, the portfolio manager has all day to make their trades before the new portfolio is shown to the public the next day. I have yet to see any study that transparency causes an active money manager to underperform.

The odds of consistently beating the market are stacked against investors. It’s been proven among various asset classes along with different types of product structures. Do you think active ETFs are the exception?

I don’t think the structure can significantly help. The difference is the portfolio manager; there are a significant number of portfolio managers who have beaten their benchmarks. I do believe the operational efficiency of the ETF structure can slightly help performance by reducing some of the internal operating expense drag that a traditional mutual fund has. We know based on assets that investors favor actively managed strategies (80 percent of the equity mutual fund assets are actively managed according to the ICI); however with transparent active ETFs, investors can be assured there would be no window dressing that might go on in other less transparent structures.

Lipper did a 10-year study showing how buy-and-hold mutual fund investors sacrifice roughly 1-to-2 percent per year due to tax inefficiency. How should this impact the way financial advisors construct portfolios?

I think if 1-to-2 percent in tax inefficiency helps you avoid a 10 percent draw down, it’s worth it. Certainly being as tax efficient as possible is a smart approach. This is certainly one of the benefits putting active strategies into an ETF structure.

How do the annual expenses for actively managed ETFs compare to actively managed mutual funds?

I believe all of the active ETFs are less than the average for their comparable mutual fund equivalent. Blackrock lists an average 0.56 percent expense ratio for all active ETFs.

The AdvisorShares TrimTabs Float Shrink ETF (TTFS) has a unique investment strategy. How does it work?

The concept is very straightforward. The key premise is that stock prices are a function of liquidity rather than value. Like the prices of any tradable good, the prices of stocks are driven by supply and demand. Supply is measured by a company’s activity in buying or selling their own shares, and demand is measured by how much cash is flowing in and out of the market. TrimTabs has been providing this research to institutions for over 20 years, and they are now finally offering a packaged solution that implements this research.

Most active ETFs have a limited performance history. What factors should advisors consider before diving in?

The main factor is a manager’s track record. Managing money in a new product doesn’t really change the skills of the manager. We have run into this with our WCM/BNY Mellon Focused Growth ADR ETF (AADR). The investment team, WCM Investment Management, has been running their international growth strategy for six years, with outstanding performance over their benchmark. The ETF is a year old, and is continuing to beat its benchmark, though we have not raised significant assets. Investors look at the track record of the ETF and not the manager, and they are missing out an opportunity to add alpha to their portfolio.

What type of AUM do actively managed ETFs have and what trends in this marketplace do you see ahead?

As of the end of June 2011, there were 40 active ETFs, with $5.4 billion in assets under management. We see a lot of growth ahead. However I would caution [against] having overly high expectations. There are significant regulatory limitations for getting new products to the market, and investors will still look for a three years track record. As a comparison for potential growth, the first three years of index ETFs (1993-1995), at the end of the three year time frame, there were two index ETFs, and $1.2 billion in assets. For active ETFs, 2008-2010, there were 31 active ETF and $2.9 billion in assets. With 80 percent of equity assets in mutual funds in active strategies, there should be much growth ahead for ETFs. I think when our children are investors, they will be surprised we gave our money to companies to manage and not be allowed to see where the money is invested, and they will be surprised to hear that we could not have control over price (limit orders) and timing (intraday execution) of our fund investments.

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