Actively-Managed ETFs have now been on the market for more than 2 years. Many people question how much of a success Active ETFs have been, given that the total assets managed by Active ETFs in the US are only about $225 million, with half of those coming from PIMCO’s Enhanced Short Maturity Fund (MINT: 100.19 -0.04%) alone. But if you speak to the issuers, most are not surprised or disappointed. Invesco PowerShares’ SVP of Portfolio Strategies, Ed McRedmond said in an interview, “We always believed that actively-managed ETFs would take some time for investors to gain understanding and comfort level”. So what are the challenges that Active ETFs are facing and what are issuers doing to overcome them?
1. Lack of a track record
When people look at investing in Index ETFs, their biggest concern probably isn’t the skill of the manager – after all, tracking an index shouldn’t be very hard. Though, when it comes to active management, investors focus a lot more on the people behind the curtains. However, Active ETFs, being such a new product, don’t have significant track records.
The issuer’s answer: One solution that appears to be working for issuers is to have established mutual fund managers having long track records, to start running their Active ETF products – but with their investment mandates largely unchanged. For example, PIMCO very recently launched its Short Term Municipal Bond Fund (SMMU: 50.065 -0.03%), with the assets being managed by John Cummings – EVP at PIMCO, who has a solid track record. Of course, SMMU itself doesn’t have a track record yet, but what investors can gain confidence from is the fact that John Cummings himself also manages the PIMCO Short Duration Municipal Income Fund A, which is a mutual fund whose investment mandate and strategies are nearly identical to SMMU. So even though SMMU doesn’t have any performance history, investors can definitely look at the equivalent mutual fund’s performance to build some trust in SMMU.
2. Investor interest in Active ETFs
Any new innovation takes a while to transition from being “new, unknown and complicated”, to being “useful, accepted and essential” for purchasers. Once the advantages of a new product are well-known, acceptance becomes easier. However, is 2 years a too long of a time for this transition to happen for Active ETFs? Is this a sign of fundamental disinterest in Active ETFs or is it just a longer than usual transition period?
The issuer’s answer: Again the issuers were not expecting to take the investing world by storm, even though the build up to their launch in 2008 made Active ETFs look like the “holy grail”. Instead, issuers are looking to educate retail investors on the obvious advantages of Active ETFs over actively-managed mutual funds. Issuers also want to convince financial advisors of the benefits of Active ETFs, since they are often the gatekeepers to many portfolios. In a study conducted by Financial Research Corp, 48% of advisors who were polled believed these ETFs will gain traction and replace active mutual funds. This process will likely take a while, just as investors took some time to warm up to Index ETFs.
3. Disclosure drama
Dealing with the daily disclosure requirement of ETFs was a huge hurdle that had to be overcome before the SEC allowed the first Active ETF to come to market. The issue is that with active managers disclosing their portfolio holdings daily, there is potential for front-running by observing traders who can duplicate the portfolio manager’s strategies. And this very issue also kept traditional active managers from jumping into the Active ETF space. One manager put it very aptly in a WSJ article – “I don’t like performing stark naked in Times Square.”
The issuer’s answer: As William Thomas, CEO of Grail Advisors, said it, “Their view [those of the active managers] is that transparency is not really an issue. It’s a competitive advantage.” Issuers of Active ETFs believe that providing daily disclosure enables investors to know what’s going on in their portfolios and helps build trust in the products. This compared to mutual funds which usually provide disclosure only on a quarterly basis.
Ultimately, all new products experience some challenges. Index ETFs didn’t gain acceptance into the market the instance they were launched. Today, you have Index ETFs managing about 3 times the amount of assets managed by index mutual funds. In time, Active ETFs could well be grabbing market share from actively-managed mutual funds in the same way and making inroads into retirement portfolios.
Disclosure: No positions in Active ETFs.
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