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Actively managed ETFs were first launched in the U.S. in 2008 offering benefits previously unavailable to investors. But their popularity has remained limited due to portfolio disclosure requirements favoring mutual funds as the preferred vehicle for active management. However, an announcement by the Securities and Exchange Commission in November 2019 permitting new types of active ETFs (known as semi-transparent ETFs, non-transparent ETFs or Active Non-Transparent “ANT ETFs“) is expected to spark renewed interest and accelerate the growth of active ETFs throughout 2020 and for years to come.
Actively managed ETFs, often referred to simply as active ETFs, are exchange-traded funds that invest in securities like stocks and bonds chosen by the fund’s manager rather than passively following an index or a rules-based strategy. As with actively managed mutual funds, the performance of an active ETF is dependent upon the investment selection of the manager whose goal is to outperform a market benchmark. The lower cost of active ETFs increases the likelihood of achieving this goal by reducing the investment returns required by the fund manager.
In this article, we highlight the benefits and limitations of Active ETFs vs actively managed mutual funds, followed by a discussion of the industry landscape through 2019. We then preview forthcoming innovations to active ETFs that stand to disrupt the status quo of active management and level the playing field vs passive investments.
There are a number of potential benefits offered by active ETFs relative to actively managed mutual funds. Four of the most meaningful benefits include lower costs, tax-efficiency, an ability to buy and sell during market hours and additional trading flexibility.
Active ETFs combine lower costs with the potential for higher returns than an actively managed mutual fund with a similar investment process and portfolio due to inherent cost advantages of exchange-traded funds.
While generally more expensive than passive ETFs and index funds, the elimination of sales charges that compensate financial advisors and operational expenses for large shareholder servicing departments results in the potential for active ETFs to be priced much cheaper than an actively managed mutual fund equivalent.
This lower cost helps fund managers improve net investment returns to investors that would otherwise be lost to operational expenses or paid to financial advisors.
Active ETFs offer the opportunity for improved tax-efficiency similar to passive ETFs, benefiting from attributes of exchange-traded funds not available in traditional mutual funds. Because investors can buy and sell ETF shares on a stock exchange just like stocks, portfolio managers do not have to raise cash when there is enough marketplace liquidity to fill sell orders.
In the case of large orders, market makers known as authorized participants can create or redeem ‘creation units’ in exchange for a basket of securities held by the ETF. This in-kind creation and redemption process avoids the sale of securities and hence capital gains taxation.
Investors can buy and sell shares in active ETFs during the trading day while the stock exchange is open, unlike an actively managed mutual fund which is generally priced only once each day after the market close.
While an advantage of a mutual fund’s pricing structure is an assurance that shares will be transacted at the fund’s net asset value (NAV), a disadvantage is that investors will not know the NAV at any point during the trading day and will only learn the NAV after the market close.
Active ETFs can be traded beyond just buying and selling shares outright; The exchange-traded structure of ETFs allows the shares to be sold short and also allows for the use of margin when purchasing shares, options not available for traditional active (or passive) mutual funds.
While active ETFs offer many potential benefits, investors should consider structural limitations that may result in an actively managed mutual fund or other investment vehicle being preferable to active ETFs.
On days when market and trading volatility is higher than normal, active ETFs might experience a relatively large spread between the market price of the fund and the fund’s net asset value (NAV) known as a discount or premium.
A discount to NAV means that the fund is trading at a lower share price than the per share value of the ETF’s underlying holdings. If the ETF is traded at a premium, this means the share price is higher than the combined value of the fund’s holdings on a per share basis.
To minimize the frequency and magnitude of ETF shares trading at a premium or discount to NAV, authorized participants play a valuable role stepping in to execute trades intended to bring an ETF’s share price back in line with its NAV.
Regulations requiring daily disclosure of portfolio holdings in active ETFs preserved the status of mutual funds as the preferred vehicle for active management through 2019. Unlike passive investments in ETFs and mutual funds where portfolio transparency inherently reflects the holdings of the index being tracked, actively managed mutual funds are permitted to disclose holdings much less frequently to protect the fund manager’s intellectual capital and mitigate unscrupulous trading activity.
Until 2019, the Securities and Exchange Commission (SEC) treated actively managed ETFs just like passive ETFs, limiting active ETF product development to strategies least affected by daily transparency requirements. However, a long-awaited announcement by the Securities and Exchange Commission (SEC) in November 2019 approving new types of active ETFs known as semi-transparent ETFs or non-transparent ETFs could even the playing field as we discuss below.
While additional regulatory relief from the SEC for semi-transparent and non-transparent ETFs in the future may alleviate the issue, existing portfolio disclosure requirements and efforts to minimize deviation of an ETF’s share price from its NAV restricts active ETF from investments in international equities traded on a foreign exchange and creates challenges investing in certain areas like small cap stocks.
For example, a stock that trades on a foreign exchange, in a different time zone, results in times when the market on which the active ETF is listed is open but the market on which the underlying stock is listed is closed.
Active ETFs combine the potential benefits of active management traditionally offered through mutual funds with the lower cost and tax-efficiency of ETFs, popularized in recent years primarily through passive ETFs. This table provides a comparison of product attributes for active ETFs vs active mutual funds and passive ETFs.
|Attribute||Active ETFs||Active Mutual Funds||Passive ETFs|
|Seeks to outperform the market or its benchmark||Yes||Yes||No|
|Relies on the active security selection of a fund manager||Yes||Yes||No|
|Tracks an index or popular benchmark||No||No||Yes|
|Trades on one or more stock exchanges||Yes||No||Yes|
|Can be sold short||Yes||No||Yes|
|Can be purchased on margin||Yes||No||Yes|
|Relative cost (typical)||Moderate||Highest||Lowest|
For more than 10 years following launch of the first actively managed ETFs in 2008, asset growth in active ETFs remained muted. This was primarily due to regulatory requirements that portfolio holdings be disclosed daily, unlike actively managed mutual funds permitted by the SEC to only disclose holdings on a monthly or quarterly basis. While daily transparency of portfolio holdings isn’t a significant issue for an index tracking ETF, this disclosure can be a disadvantage for active managers and potentially detrimental to fund performance.
One reason why active managers are concerned about disclosing their portfolio holdings daily is the potential for front-running by traders. Front-running involves buying or selling a stock based on knowledge of a portfolio manager’s ongoing investing activity that results in potential profits to the trader instead of investors in the actively managed fund or ETF.
Another concern among active managers regarding daily portfolio holding transparency is the ability for the active fund to be easily replicated by competitors or investors. One portfolio manager summed up how he feels about managing an actively managed fund with real-time disclosure of portfolio holdings by saying: “I don’t like performing stark naked in Times Square.”
To combat these concerns, industry stakeholders like Precidian Investments began to petition the SEC for regulatory relief to put active ETFs on a more even playing field with actively managed mutual funds. During this time, a handful of asset managers launched active ETFs primarily investing in fixed income securities where front-running and portfolio replication concerns were limited.
The most successful active ETF launched during this period based on assets under management at the end of 2019 was the PIMCO Enhanced Short Maturity Active Exchange-Traded Fund (ticker symbol: MINT) launched in November 2009. Five of the ten largest active ETFs at the end of 2019 were in the ultra-short bond category, with three others also in the bond space. None of the top ten invest in a core domestic or international equity asset class.
|Name||Ticker||Net Assets ($ Billions)||Style|
|PIMCO Enhanced Short Maturity Active ETF||MINT||$13.7||Ultra-short Bond|
|JPMorgan Ultra-Short Income ETF||JPST||$10.2||Ultra-short Bond|
|iShares Short Maturity Bond ETF||NEAR||$6.4||Ultra-short Bond|
|First Trust Preferred Sec & Income ETF||FPE||$5.0||Preferred Stock|
|First Trust Enhanced Short Maturity ETF||FTSM||$4.9||Ultra-short Bond|
|First Trust Low Duration Opportunities ETF||LMBS||$3.9||Short-term Bond|
|SPDR DoubleLine Total Return Tactical ETF||TOTL||$3.3||Intermediate Core-Plus Bond|
|PIMCO Active Bond ETF||BOND||$2.9||Intermediate Core-Plus Bond|
|First Trust North American Energy Infrastructure ETF||EMLP||$2.8||Energy Limited Partnership|
|Invesco Ultra Short Duration ETF||GSY||$2.7||Ultra-short Bond|
Source: ETF.com and fund profile pages on ETF issuer websites
With $56 billion in assets among the top 10 active ETFs compared to $1.2 trillion in assets among the top 10 passive ETFs at the end of 2019, some industry observers have considered this period a golden decade for passive investing. But an announcement by the SEC in November 2019 has some industry observers questioning if the dominance of passive ETFs will continue for the next 10 years or if actively managed ETFs are now positioned for rapid growth.
On November 14, 2019, the SEC publicly announced its intention to approve new and innovative ETF structures that permit actively-managed ETFs to not publish their holdings each day. These new types of ETFs are commonly referred to as semi-transparent ETFs or non-transparent ETFs (also abbreviated as ANT ETFs).
This announcement was welcomed by many of the largest asset managers and stock exchanges in the U.S. who had presented numerous proposals to the SEC over several years seeking relief to launch actively managed ETFs that preserve the cornerstone feature of actively managed mutual funds – delayed disclosure of portfolio holdings.
While mechanical differences exist among the new active ETF structures approved by the SEC, common features include the ability for fund managers to delay full portfolio disclosure by at least 30 days following the end of each month. Additionally, each structure requires enhanced board oversight intended to ensure market prices for ETFs trade in line with the underlying portfolio net asset value.
An additional condition of the SEC’s approval of semi-transparent and ANT ETFs limits potential investments to securities that trade on an exchange with the same operating hours as the ETF itself. This is intended to reduce the risk of an ETF’s share price deviating significantly from its NAV in situations where a security traded on a foreign exchange is closed while the U.S. markets remain open and subject to price fluctuations. While this condition may be revisited by the SEC in the future, actively managed ETFs seeking foreign exposure will be limited to investments in American Depository Receipts (ADRs).
Investors can expect to see many new semi-transparent ETFs and ANT ETFs launched in 2020, especially among traditional managers of actively managed mutual funds. It remains to be seen if most of these new active ETFs will replicate existing actively managed mutual funds or pursue new investment strategies. Asset managers will also weigh the merits of converting actively managed mutual funds entirely to an active ETF, an action that requires careful consideration and the approval of multiple stakeholders.
While asset growth in actively managed ETFs was limited through 2019 primarily due to regulatory constraints and investor appetite for passive investing, the next decade could represent a golden era for active ETFs and their issuers. Traditional active managers converting mutual funds or expanding their lineup to include lower cost and more tax efficient active ETFs will remove a major impediment that helped tilt flows towards index funds and passive ETFs in recent years.
The success of active management remains contingent upon a fund manager’s ability to outperform its benchmark. Active ETFs help issuers improve their odds through reduced costs that lower the investment returns required for a fund manager to achieve this goal.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.