Cowabunga! Testing the Active ETF Wave

Actively managed exchange-traded funds occupy only a tiny corner of the now-vast ETF world. Though small in number, they have been mighty in grabbing attention. So far, though, actively managed ETFs have not lived up to their hype as financial services’ Big New Thing.

“The space has been long on smoke and short on fire. It’s just a drop in the bucket in the grand scheme of things. Many were expecting the success of PIMCO’s Total Return ETF (BOND) to be the catalyst, but that hasn’t happened. It’s tough to tell what it will take for the space to really take off, if it does at all. But no singular item will move the needle,” says Ben Johnson, director of passive fund research, Morningstar, in Chicago.

Totaling assets of $14,427,770,639, actively managed ETFs represent less than 1% (0.94%) of the big ETF $1,534,310,188,007 market, as of July 31, 2013, according to Morningstar. Of the 1,497 ETFs available, only 321 are actively managed. Further, about two-thirds of actively managed ETF assets are in only one ETF: PIMCO’s BOND.

Providers of actively managed, however, are out there pitching.

They stress that in their first five years, actively managed ETFs—which debuted in 2008—have grown faster in number and assets under management than did index-based ETFs in their initial five years. The first ETF came on the scene in 1993. Actively managed ETFs saw a 78.96% increase in AUM from July 2012 through July 2013.

“Now financial advisors can run a portfolio just like institutional investors do. The process of hiring and firing managers is now as simple as a ticker symbol and a brokerage trade,” says Noah Hamman, CEO of AdvisorShares, an issuer of actively managed ETFs only and based in Bethesda, Md.

Clearly, the key to success in actively managed ETFs lies with the manager. “The fact that a fund is actively managed isn’t a panacea in itself. The manager needs to be skilled and add value, and the approach has to make sense. Advisors need to understand where the advantages are,” says Ryan Issakainen, senior vice president and ETF strategist at First Trust Advisors, headquartered in Wheaton, Ill., offering five actively managed funds of a total 72 ETFs.

It’s no secret that index ETFs increasingly have been taking big bites out of the traditional mutual fund market. It is this space that is most vulnerable to the power of actively managed, providers say.

“If you push away the 401(k) market and the insurance base, there are probably $6 trillion of taxable mutual fund assets out there, of which about 60% are no-load. That,” Hamman says, “is the opportunity in the marketplace for actively managed ETFs.”

Right now, most of the action is in bond funds as opposed to equities. As for the buyers: “People investing in actively managed tend to be small investors, and they’re not very many of them,” says Gary Gastineau, president of ETF Consultants, based in Bonita Springs, Fla., and author of The Exchange-Traded Fund Manual (Wiley Finance, second edition 2010).

So far, the advisors most attracted to actively managed are fee-based versus commission-based, and that trend is expected to continue.

It may be that many FAs shy away from actively managed ETFs because they feel ill-equipped to invest in them. A research study by Cerulli Associates, released in July, shows that FAs are notably hazy on ETF liquidity and how the funds are traded.

Yet, according to a Cogent Research report released this past July, “For the first time ever, advisors say they are as likely to invest new dollars in ETFs as they are to invest in mutual funds.”

Seeking Winners

When it comes to actively managed, Step One is to determine if the asset class under consideration would benefit from the active approach. Certain asset classes have inherent “peculiarities” in indexing that active management might overcome, says Issakainen.

“Determine where there are flaws in the index-based approach and a solution through active management,” Issakainen continues. As an example, he points to the below-investment-grade credit space. Index-based investing weights a portfolio to the largest issues of debt. “That fails the common sense test.”

Step Two is to research managers’ strategies and records of risks and returns.

“You don’t want to own an actively managed ETF just because it’s actively managed,” Issakainen says. “You still have to have a manager with a track record that he’s developed over three to five years.”

Providers emphasize active management’s goal to outperform the indexes and managers’ risk-management capabilities.

“Now, for the first time, advisors can transition more of their clients’ assets into a product that has an alpha-seeking investment objective but with the flexibility and transparency that index-based ETFs have,” Hamman says.

With interest rates rising, risk management has become more important than ever. But “it’s not just interest rate risk but also credit risk and the risk of certain industries and geographies,” Issakainen points out. “An active manager can mitigate those risks. In most instances, with an index-based approach, you don’t have that flexibility.”

Though a number of firms have filed with the SEC for permission to offer actively managed ETFS, few have launched them. Part of the reason is the lengthy approval process. Another side is that “all the actively managed mutual fund companies have filed because they want to be there should they be forced into the ETF space if they’re suddenly unable to compete outside ETFs,” Issakainen says.

Also, “the reason we see so many filings but few actively managed mutual fund companies jumping in with two feet is that, in many cases, if they get into the ETF space, they’re going to have to cut their fees. So some of the larger fund companies hesitate because they can charge more with an open-end-fund chassis as the vehicle that’s delivering their management,” Issakainen says.

In addition, firms are filing to introduce actively managed short-duration fixed-income ETFs as an option to protect them against “unfavorable regulation that may come about pertaining to money market mutual funds,” according to Johnson.