From the October 2012 issue of Investment Advisor • Subscribe!

September 25, 2012

The Future of Actively Managed ETFs

The incentive for good active managers to enter the ETF industry will be too large to resist.

The ETF industry will continue to evolve, bringing more challenges and more opportunities. The ETF industry will continue to evolve, bringing more challenges and more opportunities.

In the months leading up to the launch of the first actively managed ETFs a few years ago, ETF industry commentators were generally divided into two camps. On one side were those who believed that actively managed ETFs would be a game-changer, while on the other were those who suggested that these funds would ultimately fail to attract significant assets and die on the vine.

In hindsight, both forecasts have proven to be too extreme, as the successes and failures of actively managed ETFs have been more nuanced. And yet, the short history of actively managed ETFs provides valuable information about what the future might hold for this category of funds.

One complication in determining just how successful actively managed ETFs have been so far is the fact that there is a gray area between active and passive approaches. For example, an ETF is generally considered passive when it tracks an index; however, many indexes now follow rules that seek to deliver better risk-adjusted returns (or alpha) than traditional benchmark indexes. Should these ETFs be classified as active since they seek alpha, or should they be classified as passive since they follow an index?

In either case, many of these funds have gained a significant following over the past several years, especially for investors and financial advisors who still believe in active management, but are drawn to the tax efficiency, transparency, potential cost savings and intraday liquidity of ETFs versus traditional mutual funds.

By the same token, there are those exchange-traded products (ETPs) that are technically actively managed since they don’t track indexes, but whose objectives are to simply deliver market returns. Many of the largest currency ETPs fit into this category as they seek to deliver returns that are reflective of the change between two currencies, not to improve upon those returns. While many investors are likely unaware that these ETPs are considered active, to the extent that returns are in line with their objectives, and investors have an efficient vehicle with which to either speculate on the direction of various foreign currencies or to hedge currency risk, this distinction is essentially irrelevant. Generally speaking, the success in asset gathering, as well as the utility of this group of ETPs, has developed irrespective of its active or passive classification and will likely continue as such.

Finally, there are those ETFs that are classified as actively managed, but also seek to deliver better risk-adjusted returns than the market, similar to traditional actively managed mutual funds. This is the group of ETFs that most financial advisors think of when considering the level of success of actively managed ETFs in general. While some ETFs in this category have been quite successful in gathering assets, many others have thus far failed to attract investor interest, leading some of these funds to close down. This may be due to the fact that investors recognize that not all portfolio managers are equally skilled in delivering alpha and that most actually underperform their respective benchmarks. For example, according to S&P Indices Versus Active (SPIVA), less than a third of large-cap core managers outperformed the S&P 500 during the five years ending in 2011. Therefore, in order to attract new investors, an ETF sponsor must either wait patiently for a new fund to develop a track record that demonstrates the portfolio manager’s skill, or it must employ a well-known manager who already has a proven track record. Essentially, this is the same dilemma faced by traditional actively managed mutual fund companies.

This presents a challenge for fund companies, since many of the best active managers are hesitant to publish their holdings on a daily basis, fearing that other investors might mimic portfolio changes, thereby influencing the price at which the fund might buy or sell its holdings. Additionally, mutual fund companies considering whether or not to offer actively managed ETFs alongside traditional actively managed mutual funds must weigh the risk that an ETF might cannibalize investor dollars that would otherwise have been allocated to the traditional mutual fund.

And yet, despite these concerns, there have now been a few success stories in which well-respected managers have made the transition to ETFs without much difficulty. As new asset flows continue to favor ETFs over traditional mutual funds, I believe the incentive for good active managers to enter the ETF industry will be too large to resist. If this shift does take place, actively managed ETFs will undoubtedly cannibalize asset flows from traditional funds, but these ETFs may also win back investors who have eschewed traditional mutual funds, not because they no longer believe in active management, but instead, due to the potential advantages offered by ETFs in terms of cost, transparency, tax-efficiency and tradability.

While the jury is still out on how actively managed ETFs will change the investment landscape, there can be little doubt that the ETF industry will continue to evolve in the years ahead, offering new innovations to investors and blurring the line between active and passive. As it does, the need for ETF investors to evolve in the ways in which they evaluate ETFs will also increase. While some may dislike the added complexity brought on by change, more opportunity will arise for investment professionals to add value through sound advice.

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