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The Next Evolution of Active ETFs: Mutual Funds

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Some people may think the ETF space has reached a saturation point. However, proliferation should not be confused with real enhancements surrounding the structure and operation of ETFs. As an actively managed ETF provider, I am often asked when active ETFs are going to take off. I usually reply that they have, and remind people how small the index ETF space was seven years removed from its inception.

Context matters, and in some cases, active ETFs do not possess the same investment strategy options as their index-based counterparts. For example, the Securities and Exchange Commission has restrictions on certain international equity investments in active ETFs that do not apply to index ETFs. It is currently easier to launch a new custom index tracked by an international equity strategy than it is to launch an active foreign equity strategy that has been managed by a manager in a mutual fund for over 20 years.

So while the SEC has been reviewing different proposals from active managers, a big difference in what can be developed still exists between an index and active strategy. As long as that remains the case, many traditional mutual fund firms will be hesitant to offer an actively managed ETF if they cannot offer the same investment strategy founded in their existing mutual funds. Proposals such as non-transparent ETFs are still working their way through the regulatory process, however, that can be viewed as a greater benefit for the ETF manager than for ETF investors.

Despite current limitations, expect change over time and more mutual fund features to migrate to active ETFs that will continue to drive more advisors and investors to use ETFs in their portfolios. One such prominent feature is converting a track record from a different fund structure to an ETF, which has already happened. First Trust became the first firm to convert a closed-end fund into an ETF and brought over both the assets and the track record. That conversion process was not necessarily predicated on assessing performance as it pertained to an index-based strategy. Nevertheless, it exhibited what could be done with an active strategy as a track record is a critical step for advisors’ acceptance of an investment strategy. If a manager can bring a successful three-year track record to a newly launched ETF, then the fund may face a better chance of success than launching without the track record.

Another evolutionary feature will be the use of fulcrum-based management fees in ETFs. Simply put, a fulcrum management fee is one that will increase or decrease based on the performance of the portfolio manager relative to an appropriate benchmark. So if the manager outperforms, then the management fee can move higher; if the manager underperforms, then the management fee will move lower. This is not a structural feature compatible with an index-based ETF, where a manager’s goal is to track an index with little to no tracking error. However, similar to many mutual funds offered by firms such as Fidelity, Janus, Vanguard and Putnam, active ETFs could eventually utilize this shareholder-friendly pricing feature.

Such features serve as a reminder of how ETFs can become that much better. It is the financial services equivalent of the transition from flip phones to BlackBerrys to smartphones. While some have viewed a fulcrum fee as an incentive for managers to take bigger risks, that’s less of a concern in ETFs, where investors have neither paid huge sales loads nor are they potentially saddled with redemption fees. ETFs’ transparency allows investors to watch manager movements without obstruction, and shareholders always maintain the flexibility to buy and sell when wanted. Such a development represents yet another bright spot for the future of ETFs.

— Read “Advisors: Be Careful What Funds You Choose” on ThinkAdvisor. 


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