Active Management in Exchange Traded Funds (ETFs)

Table of Content

1. Introduction

2. Development of the active ETF business

3. Active ETFs – A comparison with mutual funds
3.1. Costs of active ETFs
3.2. Transparency of active ETFs
3.3. Liquidity of active ETFs

4. Managed ETF Portfolios

5. Future development of active management in ETFs

6. Conclusion

7. References

1. Introduction

Exchange-Traded Funds (ETFs) are probably one of the most important and promising innovations of financial markets in the last few years. Constructing on the first paper about ETFs from Baumgartner and Hosp (2013), which gave a broad overview about the basics of ETFs and their risks, this paper focuses on the possibilities of active asset management in ETFs and their risks. A huge innovation process currently occurs in the ETF business and broad up actively managed ETFs and managed ETF portfolios. These type of funds very quickly obtained popularity and thus it is one of the latest topics.

The paper is structured as follows: After the introduction an overview about the development of active management in ETFs is given. Ongoing section 3 describes active ETFs and compares them with mutual funds in mainly three aspects: costs, transparency and liquidity. Section 4 continues with managed ETF portfolios followed by a short outlook on the development of the active ETF business in section 5 and a conclusion in section 6.

2. Development of the active ETF business

The main idea behind ETFs is making a broad and diversified investment opportunity at low costs accessible even for small investors who were otherwise not able to invest in such a way. They originally track an index or the performance of an asset which makes them much more objective compared to actively managed mutual funds. Moreover they can be traded intraday on the stock exchange and prices are set continuously. On the other hand prices of mutual funds are only updated once a day. So at first glance the main advantages of ETFs are diversification, low costs and tradability (Etterer, 2004). Already several inventions have been made in the ETF business. Initially ETFs have been physical and actually contained the assets of the tracked index. Since approximately 2005 synthetic ETFs have grown very fast and are now nearly as important as physical ones. Some years ago the next innovation emerged, which is called actively managed ETFs or active ETFs. For active ETFs the picture looks a bit different. They are not objectively tracking an index like the passive physical or synthetic ETFs but instead try to outperform an index by active decision taken by fund managers. They decide in which assets to invest similar to the process of mutual funds. Currently many combinations between active and passive strategies do exist. Nevertheless the benefit of an objective investment which is independent of asset manager opinion and choices is not the case for active ETFs.

However they are mostly compared with mutual funds as they are considered in public to be nearly identical. This is not exactly true, as long as the definition as ”ETF” or “mutual fund” is only stating the investment vehicle which can either have an active investment style or an passive. It is important to note that also passive mutual funds do exist which have the goal to simply track an index (e.g. Vanguard 500 Index Fund which tracks the S&P 500) (Johnston, 2011). But usually one connects the word mutual fund to active management and ETF to passive index tracking.

Not long ago in 2008 Bear Stearns launched the first actively managed ETF (Light, 2012). Before the market for such funds really started to grow the Securities and Exchange Commission (SEC) announced in March 2010 that they are going to defer consideration for all investment companies making an exemptive request for the usage of derivatives in actively managed ETFs under the Investment Advisers Act of 1940. This means that one of the most important instruments for active portfolio management cannot be used any more for actively managed ETFs. The SEC started from that on a review to evaluate the usage of derivate by ETFs. From March 2010 to December 2012 the SEC received over fifty comment letters from various financial institutions and academics. After analyzing all comments the SEC decided to no longer defer consideration of exemptive requests on ETFs using derivatives. However two representations have to be addressed in order to be allowed to use derivatives. First, the assessment and management of risk referring to the use of derivatives must be reviewed and approved by the ETFs board each period. Second, the actions taken with derivatives have to be disclosed in the offering documents and reports. These disclosures have to comply with the commission and stuff guidance of the SEC. Furthermore the SEC is not approving the usage of derivatives for leveraged or inverse ETFs and they will continue to review the usage for actively managed ETFs in the next years (Champ, 2012).

Now that derivatives are somehow allowed for actively managed ETFs it is expected that some ETF providers launch new ETFs of that type. This could help active ETFs to grow more strongly in the future which has not been the case in the last years except of one active ETF that has impressively increased its assets under management within a few months from its launch in March 2012 to the end of 2012. It currently has $4.0 billion in assets. That ETF is called Pimco Total Return which is similar to the Pimco Total Return Mutual Fund apart from the non-usage of derivatives. Compared to the assets under management of their mutual fund which had around $285 billion in February 2013 the ETF is still very small. But the differences between those two may diminish as Pimco probably start to use derivatives also for their ETF version. Other providers will most likely act in the same way (Light, 2012). Overall the market of ETFs is strongly growing but still small in comparison to the mutual fund and also to the passive ETF market.

3. Active ETFs – A comparison with mutual funds

This sections deals with some major differences between actively managed ETFs and mutual funds. First the cost advantage of ETFs over mutual funds will be described which may be most crucial for some investors. Ongoing transparency and liquidity aspects are discussed.

3.1. Costs of active ETFs

It is obvious that actively managed ETFs must induce higher costs than passively managed ETFs. A team of asset managers, analysts and so on is needed to come up with decisions for the active management strategy creating costs that must be paid by investors. According to ETF Database in June 2011 the highest expense ratio of active ETFs at that time was 1.85%. The average annual costs for them were 0.72% and the cheapest active ETFs had only costs of 0.30% per year. This is actually not that much higher compared to the average costs of passive ETFs with 0.57% per year. Nevertheless active ETFs have a large cost advantage over mutual funds where an investor has to pay on average 1.40% each year. This is nearly double the expenses of active ETFs (Johnston, 2011). This cost advantage may also diminish as active ETFs are now allowed to use derivatives making their investment strategy more complex. Funds which are more sophisticated are typically more expensive at least in the case of mutual funds because they require more management resources. This imposes also a risk for those investors who are already holding active ETFs. First some active ETFs may now start to use derivatives and some probably increase their management fees due to higher complexity. Probably most private investors are not aware of such changes.

However active ETFs and active mutual funds have structural differences which make active ETFs in the end less costly for investors. In the case of a mutual fund the investor always has to purchase shares directly from the fund company. The fund manager must invest the daily inflows of cash into the existing portfolio which induces transaction and handling costs for them that are handed over to the investor. By contrast possible cash outflows force the fund manager to hold sufficient cash or immediately sellable assets to meet redemptions. Especially cash holdings are costly as long as they do not provide the same return than the assets would do that are contained in the portfolio (Johnston, 2011).

On the other hand ETFs have a simpler cost structure. ETF fund providers also issue shares, but typically in a large amount of 25,000 to 100,000 shares and sell them mostly to institutional investors. This is more cost and tax effective compared to the share issuing process of mutual funds (Cohen, 2012). Probably the biggest advantage of ETFs over mutual funds is that private investors can directly buy shares of an ETF from another investor on the exchange without making an interaction of the fund management itself necessary. Of course, purchases on the exchange also create transaction costs but they are much lower especially since online direct brokers do exist. This basic structural differences lead in the end to lower management fees for ETFs which can be a crucial aspect for some investors.

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