The debut of exchange-traded funds (ETFs) that are actively managed has been a long awaited moment for ETF insiders product developers, and other industry types. However, just how significant active ETFs will be for financial advisors and their clients remains unclear. Before you pop open any champagne and join the celebration, here are a few things to remember about active ETFs:
No Proven Track RecordHaving faith in portfolio managers means knowing that their formula for investment success works through thick and thin. Since actively managed ETFs have no historical track record, at best, they are suspect and unproven.
Restrictive RulesThe rules for active ETFs are considerably more restrictive compared to actively managed mutual funds. For example, the Securities and Exchange Commission requires active ETFs to reveal portfolio changes the day after they’re made. In contrast, mutual funds can go a quarter without disclosing portfolio holdings.
Before you buy the argument that transparency in actively managed funds is good, think again. More frequent portfolio disclosure is a definite disadvantage for active ETFs compared to other actively managed products and may end up costing shareholders some unknown future performance impact.
Rummaging the Wrong Garbage CansThe first set of active stock ETFs introduced by Invesco PowerShares in mid-April focus on companies with multi-billion dollar market capitalizations. The Active AlphaQ (PQY) is benchmarked against the Nasdaq-100 index, the Active Alpha Multi-Cap (PQZ) goes against the S&P 500, and the Active Mega-Cap (PMA) is benchmarked against the Russell Top 200 Index.
Here’s the problem: Finding elusive market beating returns in the efficient marketplace of large company stocks is the last place you want to be rummaging. Academic studies have shown that most large cap fund managers consistently underperform corresponding indexes. It’s hard to believe the results for active ETFs will be any different.
Higher CostsEven though the first series of PowerShares active stock ETFs may cost less than comparable active mutual funds, they are still substantially more expensive than corresponding large cap index ETFs, which charge between 0.07 to 0.20 percent. The PowerShares funds carry annual expense ratios of 0.75 percent.
Don’t kid yourself about expenses: 55 to 68 basis points is a huge cost disadvantage for active ETFs versus ones benchmarked to an index. Will superior stock picking and greater tax efficiency make up for these handicaps? Nobody knows, but I have my suspicions.
SummaryFor all of these reasons and more, I’m convinced that financial advisors are better off keeping their client’s core large cap holdings in index mutual funds or index ETFs that follow established barometers. In my opinion, your clients will do better than betting on active ETFs.
Funds that follow this proven investment strategy include the SPDRs S&P 500 (SPY), iShares Russell 1000 (IWB), SPDR DJ Wilshire Large Cap ETF (ELR), and the Vanguard Large Cap ETF (VV). If you hunger for the largest of large stocks, see the Vanguard Mega Cap 300 ETF (MGC) or the Rydex Russell Top 50 (XLG).
Advantages of Active ETFs–ETF product structure is tax efficient–Potentially lower internal portfolio turnover vs. actively managed mutual funds–Lower expense ratios vs. actively managed funds
Disadvantages of Active ETFs–More frequent portfolio disclosure vs. actively managed mutual funds–Higher costs vs. index ETFs–Beating market indexes over the long-run is still a loser’s game–No proven performance track record