Active mutual funds faced their first stern challenge when indexing started gaining ground and investors started putting money into passive strategies through index ETFs and index mutual funds. However, that challenge came from another discipline of investing – from people who didn’t believe in active management. So as far as active mutual funds were concerned, they were still the only option for investors who thought the market was inefficient and wanted to pursue active management. All that changed in 2008, when the first actively-managed ETFs were launched. Active ETFs are the real competitors of active mutual funds and may well be a much bigger threat to their existence than indexing ever was.
How do active ETFs trump active mutual funds?
A lot of the benefits that Active ETFs bring to investors are inherent to the ETF structure which serves as a much more efficient conduit for an active strategy for the following reasons:
The average cost in 2010 for an actively-managed mutual fund is 1.21% while the average expense ratio for actively-managed ETFs on the market in 2010 has been about 0.70%. Most studies that have been done conclude that active mutual funds’ performance can marginally beat the market over the long run, but that outperformance becomes negligible or even negative once the fees are taken into account. Hence, with a reduced expense ratio, Active ETFs provide a distinct advantage to investors as it gives them a better chance to outperform the market and leave more in investor’s pockets. Naturally, Active ETFs have a higher expense ratio than their indexing counterparts due to higher trading costs, but they Index ETFs do not compete directly with Active ETFs.
The ability to have in-kind creation and redemption allows investors to avoid adverse tax consequences that are experienced by mutual funds which involve cash transactions when units are redeemed. This mechanism of ETFs minimizes taxable capital gains that result from redemptions. Another option that Active ETFs have is the ability to exchange part of their portfolio and transfer out unrealized gains by creating baskets of securities and exchanging them with an authorized participant. This enables the ETFs to minimize realized capital gains and hence taxes.
ETFs have always been known for the enhanced transparency that they provide to investors and coming through 2008/2009, that transparency and clarity in what their fund holds is more precious to investors than ever. Mutual funds usually make quarterly disclosures on their holdings. A quarter is a long time in markets these days – if you were talking about a quarter in late 2008 or early 2009, you could have seen the Dow drop 5,000 points and still not know what was happening in your mutual fund. Active ETFs are required to make daily disclosures of all their holdings.
Unlike mutual funds, investors in Active ETFs or for that matter any ETF can get in and out of their investment whenever they like and at any time during the trading day. This provides investors with a much more flexible product that they can trade to their liking. In times of market stress, this liquidity can become crucial – even if there is hardly any volume in the market, the market makers for ETFs are obliged to provide a bid or ask price to investors, albeit with a higher spread. While most Active ETFs have yet to see a substantial amount of liquidity, increasing investor interest in these products will bring with it the necessary trading volume.