Are actively managed ETFs ready to grow?

Filed in Asset Management

Tim Clift from Fundquest recently contributed an interesting viewpoint on where actively managed ETFs stand in the marketplace. This article is courtesy of OnWallStreet.

The whole article titled, “Change And Chaos Drive Demand” also covers the prospects for global equities, global bonds and commodities.

ACTIVELY MANAGED ETFs: Despite Transparency Concerns, Active ETFs Show Promise

Since their market debut almost three years ago, actively managed ETFs have been slow to gain adoption, particularly within traditional equity asset classes.

As of Feb. 15, there were 31 active ETFs with a total of $1.7 billion in assets, according to Morningstar data. That’s a tiny fraction of the total ETF market of over $1 trillion.

That can be attributed partially to a slow application and approval process with the Securities and Exchange Commission, which can take months or even years, although that process is getting quicker.

Another reason for the low numbers is the concern over transparency. Currently, ETFs are required to disclose portfolio holdings on a daily basis. This has kept many asset managers from entering this market, as they are unwilling to disclose their intellectual capital on such a short-term basis. On the equity side, despite transparency concerns, there are a few initiatives that hold promise for growth.

Less traditional asset classes, such as real estate, long-short or non-U.S. equity, tend to be less liquid and therefore less affected by transparency issues.

There is an outstanding proposal from one firm (Managed ETFs LLC) to offer non-transparent ETFs. The firm was acquired last year by Eaton Vance, and this would position them to be the first to offer such a structure. If they gain SEC approval, other managers in the equity space-who had been concerned about the transparency issue-would be more willing to launch active ETFs.

These limitations are less of an issue for active bond ETFs. With just nine active bond offerings currently available, this product is still in its infancy and it is where we expect to see the biggest asset gains. It appears to be a natural fit for active ETFs for several reasons:

Replication of bond portfolios is generally more difficult than for equity portfolios. It can be nearly impossible to purchase every bond position that a manager or index may hold. This has been one of the drawbacks of passive bond ETFs. Many of these ETFs have experienced high tracking error versus their benchmarks due to this replication challenge. Numerous passive bond ETFs use a proxy of holdings to replicate duration, quality and sector exposure to mimic an index, but have experienced varying degrees of success.

Since replication is more difficult, transparency is less of an issue for bond managers. The largest bond managers are realizing that the size and execution advantage they have in the bond markets can more than make up for the concern of anyone trying to copy their portfolios.

The ETF cost and tax structure can be more advantageous than mutual funds. The trust vehicle that is typically used for ETFs enable firms to pass on the cost savings to investors. We have already seen one firm (Huntington Asset Advisors Inc.) seek SEC approval to convert their existing mutual funds into active ETFs to gain these advantages.

Active bond ETFs are in the early stages of what will likely be the biggest area of growth within the ETF space. As more bond managers get familiar with the cost and tax advantages they can gain while not being burdened with replication issues, we will likely see active bonds as the next big wave of growth in the ETF space.