Actively-Managed ETFs to Challenge Traditional Funds

Originally published in March 2011

With 36 actively-managed ETFs trading in the US as of March 2011, and another 12 available to investors in Canada, investors now have access to active management within an ETF wrapper. Exchange-traded funds can no longer be assumed to be solely providing passive, index-based exposure to the market. Investors who have had to stick to mutual funds for many years because of their need for active management now have another option available to them. Benjamin Shepherd, writing for InvestingDaily, believes actively-managed ETFs are going to be an industry game changer.

The development and launch of active ETFs has been delayed, despite no lack of interest from issuers, because of SEC intervention. The SEC launched an investigation into the use of derivatives within ETFs in 2010 which effectively put many applications for new active ETFs on ice. Shepherd mentions that observers expect the SEC to conclude their investigation soon. This would be a definite boost to many ETF manufacturers and asset managers, many of whom have waited – quite literally – years on end to get approval for their new product launches.

ETFs have been popular with retail, self-directed investors for quite a while now, thanks to their liquidity, low cost, transparency and tax efficiency, relative to mutual funds. However, the majority of investor assets lie in retirement plans such as 401(k) accounts. This is an area where ETFs have made less headway. This has been because of the high level of comfort that investors already have with investors, and also the fact that mutual funds are sold to investors by financial advisors, and not necessarily bought by investors on their own initiative. There are also operational issues where a lot of plan administrators are just not set up to handle ETFs, which settle on a T+3 basis, as opposed to mutual funds which settle T+1. Here too, though, Shepherd mentions that the momentum is shifting as more and more ETF-only 401(k) plans are launched by the likes of ING Direct and Charles Schwab. Such plans will most likely have an inherent cost advantage over mutual fund focused plans which should help attract cost sensitive investors.

Many mutual fund providers are themselves recognizing the potential change in industry momentum and moving to get ahead of the trend. Large mutual fund providers such as Legg Mason, Eaton Vance and T. Rowe Price have all filed applications with the SEC to launch actively-managed ETFs. In fact, some fund advisors, like Huntington Asset Advisors and OppenheimerFunds, have even proposed converting existing active mutual funds into actively-managed ETFs as they see inherent advantages in the ETF structure for the investing public. At the same time, active ETFs are also an opportunity for large active managers to reach into another distribution channel and monetize their existing active management capabilities further.

The oldest actively-managed ETFs will be reaching their 3-year anniversary in April 2011, at which time they will likely be assigned star ratings by Morningstar. That could go a long way in providing investors comfort with active ETFs and help boost their growth trajectory even further.