Active ETFs: A Conversation with Tom Lydon

In April 2010, ActiveETFs | InFocus spoke with – Tom Lydon, President of Global Trends Investments and Editor of ETFTrends.com. Tom is probably the most public face in the ETF field and is frequently interviewed on CNBC and also cited in other forms of media. He is also the author of The ETF Trend Following Playbook. Tom talks to us about likely leaders in the Active ETF space, challenges in-store for Active ETFs as well as how their emergence will help the ETF industry as a whole.

Shishir Nigam – ActiveETFs | InFocus: The Actively-Managed ETF space has been one of the fastest growing segments of the ETF market. Where do you see Active ETFs going over the next 2-3 years?

Tom Lydon, Editor – ETFTrends.com: The next 2-3 years will be critical for actively managed ETFs.  Despite their many benefits – particularly over mutual funds – they haven’t been explosively popular with investors since they first appeared, but that’s because they need to go through a period of proving themselves and proving that they can generate alpha and that they’re worth the slightly higher cost over passive, index-tracking ETFs. If they can, investors will come.

Shishir: Which players do you think will assume leadership in the Active ETF space?

Tom: Players who put their expertise in a given asset class to use should do well in active management. For example, no one does bonds better than PIMCO. Investors can get access to that expertise and knowledge simply and inexpensively by investing in one of PIMCO’s active funds. You’re getting the kind of expertise many people would pay handsome money for, and you’re doing it with a well-known name. We’re also seeing other big, well-regarded money managers get into the space, too, such as Goldman Sachs and JP Morgan. Names that people know and respect should be able to attract a following.

Shishir: Do you see the large mutual funds players that are entering this market, like Legg Masson and Eaton Vance, competing effectively with more traditional ETF players like PowerShares and iShares?

Tom: I don’t see it so much as competition as I do a complement to existing offerings. Actively managed ETFs aren’t meant to replace traditional ETFs, but to be another value-added offering and a way for investors to get additional diversification in their portfolios. The entrance of these big, well-known names will only further serve to help the ETF industry by increasing its profile with investors who may not be aware of them or convinced that they’re useful for them.

Shishir: Are Active ETFs are ready to take market share from Actively-Managed Mutual Funds, which are still very ingrained, especially in retirement portfolios and 401(k) plans?

Tom: Not quite yet. Maybe someday, but the mutual fund industry is a behemoth, and as popular as ETFs have become, they still only account for 6% of mutual fund market share. Actively managed ETFs are going to have to prove that they can deliver on the performance side and attract enough investors to truly compete head-to-head with mutual funds.

Shishir: What do you see being the main challenges facing the Active ETF space?

Tom: The main challenge is what I mentioned above, that actively managed ETFs will need to prove that they can generate alpha before they really lure in investors. Right now, while funds that have launched have been well-received, there’s still a lot of “wait and see” going on. The managers behind these funds will need to prove themselves, and everyone is watching right now. If the managers do well and generate alpha, actively managed ETFs will be a success.

Shishir: Will conversion of existing mutual funds into actively-managed ETFs become a popular way for mutual fund players to enter this market?

Tom: Yes. In fact, we’re already seeing signs of this happening in the space. Many of the big names that have launched funds or filed to launch funds are opting to do it as active managers. It’s a format that they know and with which they are comfortable.  It’s an easy way for them to make the transition while not going too far out of their element.

Shishir: Do you think there’s a market for Actively-Managed ETFs in Asia?

Tom: Definitely. In fact, Asia in general is seen by some as an ETF market with huge potential for growth in the coming years. That growth will extend to all asset classes and ETF types, and active funds are no exception. But they will be viewed similarly to the way they are here, in that active managers will need to prove themselves first before the assets truly roll in.

Shishir: Asset under management in US Active ETFs increased by roughly $88million to $362million in March. Is the growth rate for Active ETFs going to be anything comparable to that experienced by Index ETFs over the last decade?

Tom: Right now, that’s up in the air. Actively managed ETFs stand to be very successful, but two things really need to happen. The first, of course, is that they need to deliver on performance. The second is investor education. Many may be wondering why they should buy an active ETF when there are active mutual funds. What’s the difference? There’s a huge difference. Actively managed ETFs have huge benefits over actively managed mutual funds – transparency, intraday liquidity, lower fees, etc. – and it will be a matter of getting that understanding out there.

Shishir: Would you say that the arrival of Active ETFs on the financial scene is a boost for the ETF industry as a whole, as these products target an entirely different category of investors?

Tom: Absolutely.  Actively managed ETFs will open the ETF industry to an entirely new audience. Some passive ETF investors may find them appealing for diversification and flexibility, and mutual fund devotees who like the format but are tired of high fees, lack of liquidity and investment minimums may finally be convinced to make the switch over to ETFs. The development of active ETFs also has opened the door for more competition in the ETF industry, as well, which only benefits investors.