Active ETF Basics: Active ETF vs Mutual Fund

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When the first mutual funds appeared on the scene in the 1920s and subsequently exploded in their numbers in the 1950s and 1960s, most investors utilized these funds to access actively-managed portfolios. That largely held true until the first retail index fund was launched by John Bogle in 1976, the same fund that is now the Vanguard 500 Index Fund. And until a few years ago, investors looking for active management of their money could only look to mutual funds. However, with the launch of actively-managed exchange-traded funds (ETFs) in the US in 2008, investors looking for active management gained the option of investing through ETFs, an option that passive investors have long enjoyed.

The ETF structure brings with it some important differences that investors have to be cognizant of, especially if you are used to investing through mutual funds. These differences can prove to be advantageous for investors compared to other investors who have their money in active mutual funds. There are several primary distinguishing factors between actively-managed ETFs and active mutual funds.

1. Transparency Requirements*

The first fundamental difference between Active ETFs and active mutual funds is the level of transparency. Most mutual funds in the US report their holdings to shareholders only on a quarterly basis. This means that in between reporting periods, investors with money in an active mutual fund have little idea about what their fund is holding. The quarterly reporting also makes style drift harder to detect for investors. For instance, in between quarterly reporting periods, portfolio managers could well make more aggressive investments in an effort to generate return and take on more risk than investors would expect based on the fund’s investment mandate. And just prior to the period end, managers would reign in their bets and bring their portfolio back within stated limits by reporting time – a phenomenon commonly known as “window dressing”, where portfolio managers bring their portfolios back into a good shape that investors will be happy with just prior to the reporting date.

In contrast, the Securities and Exchange Commission (SEC) has historically treated actively-managed ETFs in the US just like any other ETF and required the fund to provide daily disclosure of all holdings as of the last business day on their website. For example, for PIMCO’s Enhanced Short Maturity Fund, one of the largest actively-managed ETFs, you can find a listing of every single one of the fixed-income securities that MINT holds. Such extensive disclosure ensures the accountability of the portfolio managers to a much higher degree than in active mutual funds.

* Pending Update to Transparency Requirements: On November 14, 2019, the Securities and Exchange Commission (SEC) publicly announced its intention to approve new ETF structures that will allow 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.

For an up to date discussion of actively managed ETFs, click here to read our latest article, Actively Managed ETFs: Benefits, Limitations and Forthcoming Innovation.

2. Tax Efficiency

When invested in active mutual funds, investors have to suffer tax consequences due to the actions of other investors in the fund, even though they have nothing to do with those actions. This inequity results from structure of mutual funds. When any one investor decides to sell out of a mutual fund, the fund manager has to raise cash by selling some securities if he/she was fully invested previously. The sale of those securities can result in realized capital gains that get taxed and the tax bill is footed by all investors in the fund, even those who did not sell any shares. In 2008, investors felt the full brunt of this inequity as they suffered large losses in their mutual fund holdings with equity markets crashing but still received tax bills at year end due to numerous investors pulling out of mutual funds all together.

In contrast, with Active ETFs, an investor’s tax consequences are only affected by their own actions. The exchange-traded nature of these funds means that investors can buy and sell shares in the secondary market just like stocks. Hence, the portfolio manager does not have to raise cash for small redemptions, when the secondary market liquidity is sufficient to meet the sell orders. Even in situations where there are large orders, market makers can create or redeem “creation units” in exchange for a basket of securities held by the portfolio. This in-kind creation or redemption process again avoids the sale of securities and hence capital gains taxation.

3. Intraday Pricing and Liquidity

When you are looking to get in or out of an active mutual fund, you can do so only at one point in the day, at 4pm ET and at a price that you will not be aware of until after the fact. One advantage of this mechanism is that investors can be assured that there shares will be transacted at the fund’s net asset value (NAV). However, the investors cannot know this NAV before hand and also does not know what the fund’s NAV is intraday with mutual funds just releasing the closing NAV on market close.

Actively-managed ETFs differ significantly in this aspect because they are exchange-traded, just like stocks. This means you can see the indicative value for an Active ETF at any point in the day, just as you would for a stock. However, notice that I said “indicative value” and not the NAV. Because an Active ETF trades on the secondary market, its share price can differ from the fund’s true NAV. However, the market maker or designated broker has an incentive to keep the deviation of the share price from the NAV to a minimum because they can arbitrage between the share price and the fund NAV, in the process reducing that deviation. Being exchange-traded, investors can get in and out of a fund at any point when the market is open, they see the rough price of the fund at any point, and also have the ability to use limit prices, margin or even short the fund just as they would for any stock.

4. Lower Expenses

Most actively-managed ETFs have expense ratios that are lower than those on the average active mutual fund that provides investors with exposure to a similar strategy. This is because, operationally, ETFs are cheaper to run than are mutual funds and the fund administration process is simpler. ETFs don’t really need large shareholder servicing departments that mutual funds have. Another important factor that leads to lower costs is that ETFs do not pay trailer fees to investment advisors who recommend them to investors. For mutual funds, traditional investment advisors could receive a trailer fee up to 1% which gets added on to the total expense ratio (TER), the headline expense that investors see. As a result, Active ETFs on average end up being cheaper for investors relative to comparative strategies in active mutual funds.

5. No Investment Minimums, Sales Loads

A final major difference is that most active mutual funds have minimum investment amounts to enter the fund usually between $1,000 – $5,000 for retail funds. In contrast, Active ETFs have no minimum whatsoever, as long as you have enough money to purchase a single share of the fund on the market. Active mutual funds can also charge sales loads which may be front-end or back-end, usually ranging anywhere from 1% – 5%. These loads also reduce the actual investor capital that ends up being invested or redeemed from the fund.

Balancing out that advantage though is the brokerage commission charge that investors will have to pay when purchasing an Active ETF through their discount brokerage. Also, where investors already in a mutual fund can reinvest distributions without any transaction costs, that may not be the case for Active ETFs where brokerage commissions again may come into play.

Disclaimer: The information in this article is not intended to encourage any lifestyle changes or investment decisions 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.

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