From the August 2014 issue of Investment Advisor • Subscribe!

When Active ETFs Aren't Really Active

Whatever you call them, index funds still have passive managers

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'Active hybrid' ETFs have more in common with index ETFs than actively managed funds, Hamman says. 'Active hybrid' ETFs have more in common with index ETFs than actively managed funds, Hamman says.

There has been significant discussion within the ETF space regarding non-traditional indexes, which have been called many different names, including fundamental indexes, strategic indexes, strategy indexes and, most recently, smart beta. For those who favor a low-cost index approach to investing, the evolving terminology has made it difficult to understand what fits in the universe of index investing. While ETFs have a multitude of strengths, this is an area where ETF sponsors have done a disservice to index investors.

The path leading to this point began with the convergence of two components: the rapid growth of traditional index ETFs and the SEC's review for approving transparent, actively managed ETFs. Many participants in the fund industry clearly recognized the attributes of ETFs. Prior to the introduction of the first non-traditional ETF offerings, more than 80% of equity mutual fund assets were in actively managed strategies. It was only natural that a more efficient investment structure combined with a continued strong investor appetite for actively managed strategies would drive the development of new innovative strategies. The only problem was a legal one since there was not yet regulatory approval.

As a result, forward-thinking ETF sponsors found what they believed to be a better way to get market exposure and introduced quantitative models that could be easily calculated into an index. The new products came in all shapes and sizes, including equal-weighted, fundamentally weighted and dividend-weighted among others that differed from traditional index ETFs. Time has proved those ETF sponsors right. According to Morningstar, at the end of 2013, these index strategies contained just under $300 billion in assets.

Regardless of the marketing name du jour for these indexes, the one characteristic all these strategies share is a passive portfolio manager. While most investors and advisors take comfort knowing that portfolio managers of traditional index strategies usually charge very low fees, the strategies in these new index ETFs charge considerably more. Although industry providers may indicate such ETFs don't charge as much as actively managed mutual fund strategies, which on average is true, they are often justified by calling these index ETFs “hybrid active.” It would be incorrect to say these funds do almost as much work as managers of actively managed strategies. In fact, they do the exact same amount of work as any other index portfolio manager.

Presentation can display key differentiators when evaluating an investment strategy that are not just a matter of semantics. While some index strategies—whether called fundamental, strategic, alternative or smart beta—may vamp their amount of portfolio changes as being active, that nevertheless remains commonly known as turnover, and is not active. Industry discourse continues over which older, traditional indexes—a trigger for debate over which indexes and providers—should be recognized as benchmarks. New waves of custom index strategies may be marketed as active hybrids although they still remain passively managed as any index does.

The essential reminder remains to judge both active and passive strategies based on their investment merit and results. It is prudent to pay low costs for passive strategies regardless of the indexing terminology, and to the extent where an advisor feels that an active manager is worth their fee, expect higher costs for those managers who take discretion to produce better risk-adjusted returns for clients’ portfolios.

Because of the SEC's approval of transparent, actively managed ETFs, advisors can now select from an increasing array of passively and actively managed ETFs for building and maintaining client portfolios. Over the next few years, more of these ETFs will reach their three-year anniversaries and provide advisors a better guide in assessing the skills of active portfolio managers.

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