Active ETFs: Next Evolutionary Step for ETFs – Ed McRedmond

In March 2010, ActiveETFs | InFocus spoke with – Ed McRedmond, Senior Vice President of Institutional & Portfolio Strategies at Invesco PowerShares. Invesco PowerShares was one of the first companies to bring Actively-Managed ETFs to the US market in 2008. Ed talks to us about the outlook for Active ETFs, the capabilities that PowerShares’ hopes to capitalize on to become a leader in Active ETFs and some challenges they may face in comparison to Index ETFs.

Shishir Nigam – Active ETFs | InFocus: Ed, welcome to ActiveETFs | InFocus and tell us a little bit more about yourself and how PowerShares stepped into the Active ETFs.

Ed McRedmond, Senior Vice President – Invesco PowerShares: Sure, and I clarify one thing – depending on who you talk to, PowerShares was the first to bring actively-managed equity ETFs to the marketplace but Bear Stearns probably had the first actively-managed fixed income ETF which they brought to market slightly before us. They also brought it to market right before their demise through the financial crisis, when they were bought out by JP Morgan. So the product they brought out isn’t in existence anymore but some might argue they had the first product to market. PowerShares brought our line-up to market in a partnership with a group called AER Advisors, which is based in New Hampshire. So we partnered with them to bring the products to market and they are actually the sub-advisors on a couple of the products and the others are sub-advised by Invesco, our parent company.

Shishir: As you mentioned, PowerShares launched its 5 products in 2008, that are still on the market right now. But since then, PowerShares hasn’t launched any new Active ETF products. So how do you plan to be a part of the growth that’s anticipated for Active ETFs?

Ed: Invesco PowerShares certainly believes in the future of actively-managed ETFs. If you really break it down and ask “What is an ETF?”, at its core, it’s really just a delivery vehicle for some type of an investment. In the first generation, it was a delivery vehicle for your traditional, cap-weighted, passive benchmark indices. Then it evolved into 2^nd and 3^rd generation indices, indices that were created through more of a research driven, rules-based methodology that attempted to add value through the index construction methodology or reduce risk through the index construction methodology.

And then continuing on to the most recent evolvement which is the actively-managed ETF, where it not tracking any type of index and the manager has some degree of flexibility and freedom to decide what securities they are going to buy and sell, versus simply just trying to manage to an index and the changes that occur in the index. We always believed that it was going to be a slow educational process that would take time to build up and it’s really no different than what happened to traditional ETFs. You can see that the first ETF launched in 1993, the SPDR, then you had a couple more come out up till 2000-01. Then you had a big shift and a new wave of ETFs started to come to the market and some different products. And it wasn’t really until after that point that ETFs really began to gather steam, so you had a number of years where ETFs were out in the market after the launch of the SPDR but they certainly hadn’t gathered up the steam they have now.

Likewise, we don’t expect the actively-managed ETFs evolvement will be that different. It will come out, it’ll take time for people to get comfortable and get familiar with them. But we think there’s a couple of differences there – one, unlike the index based products the actively-managed products don’t come out with some type of a track record for someone to look at. So right off the bat, most people are going to take a wait-and-see approach to get a sense of how is this performing – whether that requires a 12-month time period or a 3-year time period, that will certainly depend on the individual. Some people might be comfortable enough after watching it for 12 months, other people might wait until it’s been out for 3 years and it gets the Morningstar ranking. That’s one of the challenges that the actives have that the index based products didn’t, in that there is no immediate way to go back and judge the track record.

Number two, there’s still wait-and-see approach where people think – if an ETF is actively-managed, it’s not going to be as tax efficient as traditional ETFs have been and what people have come to expect in the way of tax efficiency. We in Invesco PowerShares don’t necessarily agree with that. We’ve always believed that certainly in the traditional equity and fixed-income space, it’s not low turnover that makes an ETF tax-efficient, it’s the structure and the creation/redemption process, being able to in-kind shares in and out of a fund – that’s really what makes an ETF tax efficient, not the fact that it tracks an index that has low turnover.

Shishir: What do you think is the critical mass that’s required for an Active ETF to be viable in the long-term?

Ed: Whether it’s active or fixed-income based, it’s hard to pin down a specific number. Obviously, it’s going to be different between ETF providers, based on the number of products they have, economies of scale, what they’re paying the underlying manager of the product which will certainly vary and that’s going to be a different number for fixed-income versus equity based ETFs. I’ve seen numbers out there where people have said at the low-end to be $30 million to $50 million to breakeven.  I think those numbers are probably in the ballpark for certainly the larger ETF providers. Obviously, if someone only has 1 or 2 products in the market and they can’t spread the cost, they might have a higher number than someone who has a 100 products in the market.

Shishir: Currently, there are only 5 issuers in the Active ETF market. But a lot of big names have filed to launch new products such as Legg Mason, Claymore and PIMCO. How does PowerShares plan to compete with these larger players entering the Active ETF space?

Ed: I think it’s a couple of things. It’s not really much different per say on the active space as in the index space. Hopefully bringing innovative products to market that people feel add value – number one. And number two – getting out there and providing the education and sales support necessary.

Invesco PowerShares has a dedicated ETF sales force both out in the field covering territories and an internal sales force; additionally we have a small institutional sales force. So there’s dedicated people out there that are working everyday with advisors, with RIAs, with institutions, telling the Invesco PowerShares’ story across our whole product line-up whether it be the index based products or the actively-managed products. In addition to that, we are part of a large global asset manager, being part of the Invesco family and that opens up another universe of people that are out there from the Invesco generalist side, they’re talking about Invesco mutual funds, separate accounts and PowerShares ETFs. That’s certainly a big part of it.

There’s also things like our PowerShares University series that we’ve been doing for a few years now, where we go out to a number of major markets throughout the year and do events that range from half a day to a couple of hours where we’ll bring in a number of industry people, talk about our whole line-up and ETF education. They’re geared towards financial advisors, professional investors – they are not opened up to the retail world. We’ve historically averaged in the neighborhood of 150-200 people at these events, so they’re very well attended and we get very good feedback. This year we’ve got more on our schedule than we’ve had the previous few years. So all those things that you need to do to support the product and get people comfortable with it. I think that we certainly have the resources in place that can compete with anybody that’s out there.

Shishir: If you were to put a number on it, what kind of market share targeting to achieve within the Active ETF market?

Ed: Our intention is that we want to be and believe that we will be major players in that space. Hard to pin down a market share number, but right now we have a fairly significant market share. Obviously the piece of the pie is still very small, so we’ll see how that number plays out in the years ahead. Again, we fully expect and intend to be among the leaders in that space.

Shishir: How do you think Active ETFs can break into the massive 401(k) and retirement portfolios which really are a very huge market for ETFs?

Ed: A couple of things – to some extent, they’re already available to the through IRA accounts or through the self-directed brokerage window that someone might have as part of their company’s 401(k) plan.  So they’ve got some degree of access already, but you’re certainly right, the large portion of the assets is fairly heavily concentrated towards mutual funds. There’s a number of reasons for that, the biggest probably being that there are some operational issues that need to be overcome on the part of the 401(k) providers. Their systems were set up to deal with mutual funds, which meant their systems settle T+1 instead of T+3. They were set up to transact in dollar amounts instead of shares amounts. Those operational things are as much of a challenge as anything else. Certainly, if you look and see what’s out there in the way of people wanting more transparency, disclosure certainly on the fee front is important. On average, the lower costs that ETFs provide seem to be something that will eventually get some traction in the 401(k) world, once some of these operational challenges are overcome.

Shishir: In 2009, for the first time, Index ETFs had a greater market share than index mutual funds in the passively managed space. Do you see Active ETFs overtaking actively-managed mutual funds?

Ed: Certainly not for the foreseeable future. It’s like the debate about active versus passive strategies – you’re always going to have people that want active management over passive index based management. And if someone decides that they want active management, then the decision is, how do I want that provided to me?

Certainly, in the world of Invesco, we can deliver active management to clients if that’s what they choose, in a number of formats – whether it be Invesco mutual funds, separate accounts or PowerShares ETFs. Again, I certainly don’t expect that the actively-managed ETFs are going to put too much pressure on active mutual funds anytime in the foreseeable future.

But the thing that gives me hope for the future is that if people want active management – there may be some potential benefits of getting it delivered to you in an ETF format because of the structure. It is more efficient from a capital gains stand point, lower expenses because of not just the lower expense ratio of the ETF but also some of the internal expenses that a mutual fund might have such as paying commissions and bid/ask spread every time a manager is buying and selling stocks. If that’s turnover is handled in an ETF through the in-kind in stocks going in and out, then the ETF shareholders are not bearing those costs, they’re not paying those commissions, they’re not paying those bid/ask spreads from the manager turning over the portfolio.

Shishir: That’s fantastic. Ed, thanks a lot for joining us and we wish you all the best for the future.

Ed: My pleasure, thank you.