From the July 2013 issue of Investment Advisor • Subscribe!

Why Actively Managed ETFs Surpassed Index ETFs

Though newer, actively managed ETFs are greater in number and AUM

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A perhaps surprising and not widely known fact is that actively managed ETFs in their first five years outpaced the growth of index-based ETFs in their first five years, in both the number of products offered and the amount of assets under management.

The attraction is simple and begins with a better structure. The ability to get index exposure prior to 1993 could be done in many ways with mutual funds, stock baskets, closed-end funds, unit investment trusts (UITs) and several derivatives. The investment strategy initially offered by the SPDR S&P 500 ETF (SPY) was not unique at all. The difference was the structural benefits of the ETF—the transparency, tax efficiency and liquidity—which also allowed investors to use limit orders with their fund holdings for the first time. Not available to end-of-day priced NAV funds, limit orders are an essential risk management tool for ETF trading, allowing investors to get execution at a price or time they want, not after a volatile day in the market (which these days can easily add 100 basis points in price movement).

Advisors who value transparency, operational efficiency and liquidity also have the ability to work with trading desks to aggregate their client trades through a market maker and potentially obtain an execution via new ETF creation units. ETFs enhance day-to-day risk analysis capabilities. When analyzing overlaps among products, viewing the holdings at the end of every trading day versus the end of a quarter is the difference between a smartphone and an old rotary phone. For example, a client conversation can go much easier when explaining an actively managed tactical fund that constantly changes holdings if in a transparent ETF.

There are two market data points that support the idea that actively managed ETF assets could continue to grow at a faster pace than index-based ETFs. The first is that index ETFs are consistently the most active trading security on any given day, a telling indication that ETFs are focused on far more than just the buy-and-hold investor. ETFs have become “beta baskets” for strategic and tactical asset allocators to implement their active strategies, meaning that beta products are being used as tools for actively managed strategies where the money manager takes on the active decisions of asset allocation. Beta ETFs are able to serve as cost effective tools for moving assets across various asset classes. The second data point comes from the Investment Company Institute and shows that as of 2012, only 17.4% of equity mutual fund assets are in index-based strategies. That amount has increased, but using dollars invested as a form of voting, investors overwhelmingly prefer active managers in the mutual fund structure.

Market Share by Strategy: Actively Managed ETFs

The beneficial structure of an ETF, combined with many investment advisors’ desire to allocate to an active manager and provide their clients better risk-adjusted returns, spurred a burgeoning actively managed ETF market that today is a robust marketplace with a variety of asset classes and strategies available.

Advisors clearly recognize not only the importance of asset class diversification, but also diversification across manager style and strategy. As advisors continue to search for better risk adjusted returns for their client portfolios, actively managed ETFs should not only continue with substantial growth, but perhaps eventually grow larger in total assets under management than index-based ETFs.

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