From the January 2017 issue of Investment Advisor • Subscribe!

Is 2017 the Year of Active Management?

A look at the youngest ETFs offers some clues

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ETFs are increasingly used as active tools by investors of all stripes. ETFs are increasingly used as active tools by investors of all stripes.

Let’s just get the answer to the question posed above out of the way: No one knows for certain, just as with any new year’s prognostication. However, every day does represent an opportunity for active management in your life — from walking across the street without getting hit by a car to actively managing your health, your kids and your relationships. Any notion that client assets should not be actively managed would be as naïve as to think that everyone shares the same investment goals, objectives and risk tolerances. As mentioned previously in this column, trading volume illustrates that the growth of index-based ETFs is far more about tactical asset allocation and investment flexibility than it is an embrace of a buy and hold approach.

The democratization of ETFs has become more evident with each new year, too. ETFs are increasingly used as active tools by mom-and-pop investors, self-directed investors, the growing millennial embrace of “robo-advisors,” financial advisors for their clients, investment companies as tools within mutual funds and closed-end funds, hedge funds and, finally, by some of the largest institutional pension, endowment and sovereign asset managers.

While a fair share of pundits point to 2017 as a year for active management to shine, a look at the youngest segment of the ETF space — actively managed ETFs — may shed light on other underlying trends. Through the end of November 2016, the average age of all active ETFs was just 2.74 years. Barring a substantial influx of new actively managed ETFs entering the marketplace, the average active ETF age will reach three years during 2017, which represents a critical milestone for review and usage by advisors.

It remains discouraging to come across other news outlets’ articles that rate successful ETFs by their assets under management. Any fund company can certainly understand that assets drive revenues; however, the industry as a whole would be far better served by basing the success of an ETF on its performance and the investment merits delivered to its shareholders.

For a mutual fund or an ETF to achieve a five-star Morningstar rating, a fund needs to be among the top 10% of risk-adjusted performers with its peer group or category average as well as carry at least a three-year performance history. Four-star funds follow within the next 20% of the best risk-adjusted performers with at least a three-year track record. Of the actively managed ETFs eligible for a Morningstar rating, 13% earned a five-star rating, while an additional 24% achieved four stars (through November 2016). While a vast variety of factors may contribute to that outperformance compared to mutual funds, both the relative and risk-adjusted results remain positive for investors and quite encouraging for the future of active management in an ETF structure.

The hope here for 2017 is that more advisors will allocate to great performance. In 2016, several ETFs closed due to small assets despite carrying five-star and four-star ratings. Consumers are willing to embrace the latest technology and try new products just as they did with the iPhone, Facebook and electric cars. As an industry, a better job can and should be done to support the best measures of success for investors and support the growth of newer products that deliver quality managers and great track records.

Making predictions can be fun, but let’s see where everything stands in December 2017. ETFs represent an area of certainty and opportunity, whether using beta to make active decisions to help meet your clients’ investment goals or accessing managers within an active ETF. Here’s to 2017 being a great year for advisors and investors alike.

--- Read Young Americans Piled Into Some Horrendous ETF Trades Right After the Election on ThinkAdvisor.

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