Are Active ETFs a Threat to Mutual Funds?

While mutual funds may still dominate the U.S. market, ETFs are gaining traction quickly. According to the 2019 Investment Company Institute Factbook, at the end of 2018, the U.S. domestic mutual funds market amounted to $17.7 trillion in total net assets. At the end of 2018, US domestic ETFs had $3.4 trillion in total net assets, which is double the assets in ETFs from just five years ago. Index domestic equity ETFs are attracting one and a half times the net inflows of index domestic equity mutual funds since 2009. Clearly, ETFs have become very popular investments in a rather short period of time and are continuing to grow.

Most ETFs today are indexed ETFs where there is no real active investment management, but rather where the fund is merely tracking some index. ETFs are fully transparent, meaning the holdings and positions are published daily, as opposed to mutual funds that are only required to disclose holdings quarterly. This full transparency has kept many investment managers from creating actively managed ETFs, as this would be revealing their secret sauce — their investment strategy — and allow front running by investors. There are a few actively managed ETFs, but most of these are from smaller, relatively unknown investment managers. Out of a universe of around 2,300 ETFs today, only 300 or so are considered actively managed, which constitute around $62 billion of the $3.4 trillion in ETFs.

Game Changer for Active ETFs

Now along comes what is called the nontransparent ETF, also known as semi-transparent, concealed ETFs or next-gen ETFs. These could be a game changer. For the first time, it will now be possible for investment managers to put actively managed funds inside an ETF wrapper and not have to worry about revealing their investment strategy. Precidian Investments has at long last received approval from the Securities and Exchange Commission for its actively managed ETF strategy, called ActiveShares.

ActiveShares, which will operate similarly to a blind trust, will only hold securities traded on U.S. exchanges, according to filings. The ActiveShares structure introduces a new middleman to the mix, known as an “authorized participant representative,” which will know the daily holdings information and work with authorized participants to create and destroy shares. Beyond that, portfolio holdings will be publicly available on a quarterly basis. So investors are left with a situation akin to investing in an actively managed mutual fund.

An indicator of how popular actively managed ETFs may become, the following fund companies have already licensed ActiveShares from Precidian: Legg Mason, BlackRock, Capital Group, JPMorgan, Nationwide, Gabelli, Columbia and Nuveen.

Advantages, Disadvantages of the Active ETF

It is a well-known fact that ETFs enjoy better performance over a comparable mutual fund, all things else being equal. Two of the main reasons for this disparity are (1) the fact that the fund manager of an ETF does not have to sit on cash to cover redemptions like a 40 Act fund, thus does not have that drag on performance and (2) the filing costs and administration of a 40 Act fund are greater than running the same fund as an ETF. For example, there are no transfer agent fees with an ETF like there are with mutual funds. When actively managed, nontransparent ETFs start showing up, don’t expect the same low expense ratios of an indexed ETF. It does cost more to run an actively managed fund, whether it be an ETF or a mutual fund.

But if an investment manager can replicate the same strategy with the non-transparency of a mutual fund but get better performance because of the lower costs by using an ETF chassis, why ever use a 40 Act mutual fund chassis? The short answer to that is one size does not fit all.

In other words, depending on who the investor is, there are pros and cons to owning ETFs just like there are with owning a mutual fund. These pros and cons need to be broken out between the two major types of account holders to better understand the pros and cons of investing in an ETF. Those two major types of account holders would be those invested in tax-deferred retirement accounts, like a 401(k) plan, and those holding investments in some type of taxable retail brokerage account. Let’s look at each one.

Tax-Deferred Accounts

ETFs are not the best investments for retirement accounts for a number of reasons. Retirement plans have been very slow adopting ETFs due to the complexity in recordkeeping and trading as they act very similar to employer stock, which any recordkeeper will tell you is a pain. ETFs can trade anytime during trading hours, but that is not so easy to accommodate in retirement record keeping systems. Most 401(k) recordkeeping systems are designed for an end-of-day valuation with trades placed after hours based on the end-of-day Net Asset Value (NAV). These recordkeeping systems are not designed to accommodate intraday trading very well.