Active Exchange Traded Funds (ETFs) may sound like an oxymoron, but when they first came out many thought they would fly off the shelf. JPMorgan estimates that active equity funds have suffered net outflows of about $1trn over the last 10 years. What better way for the big active funds companies to stem these outflows than grab the bull by the horns and join the ETF party with active ETFs?
That has not been the case. While ETFGI, the leading independent research & consultancy firm, reported that active ETFs had grown by over 30 per cent in the first half of 2017 in terms of assets under management, they remain a backwater of the ETF world, with only around 1 per cent of global ETF assets. If you bump out the very short term debt and cash ETFs, particularly from Pimco, the amount of money in active ETFs becomes inconsequential.
There is no rule that says that ETFs must be passive. An ETF is just a mutual investment strategy, similar to an investment trust or a mutual fund in many respects, albeit without the freedom to invest in illiquid assets. But you can put most of an active manager’s stock picks in them if you wanted to: ETFs are after all like glass bottles; you can put Buckfast into them or you can put in Champagne. You can put the FTSE 100 in an ETF or you could put your favourite active manager’s top stock picks.
Why have active ETFs failed to take off? I think one of the key reasons has been active fund manager secrecy. In order to function as ETFs and to be able to create and redeem ETF units, active managers must fully disclose all their holdings. Many active equity investors, particularly those with smaller cap stocks in their funds, are loath to disclose their investments as they fear they will be front run should they start to build up a position in a stock or to sell it down.
This perhaps is not such an issue for cash funds or bond funds where fund managers tend to be more long term, broadly diversified and whose portfolios tend to be less sensitive to being front run. This is perhaps why products like the $2bn Pimco Active Bond ETF, the fund formerly managed by Bill Gross, have been relatively successful.
Off the record, ETF firms tell me that there have been problems marketing active ETFs. They tell me that active portfolio managers tend to issue ETFs and then sit back and expect the ETFs to sell themselves, or at least expect the traditional ETF sales people to make the sale for them. The reality is that ETF sales people are good at selling traditional indexes and not so good at selling active managers. If you like, their address books are full of people who like to buy passive funds, but they do not know the active fund buyers, who are often completely different in many large organisations.
The Securities and Exchange Commission, the US regulator, has also been resisting active ETFs, unless active portfolio managers make full disclosure of their positions. The SEC believe, not unreasonably, that investors should be able to judge whether an active ETF is trading at a discount or a premium. Consequently, they have turned down a number of attempts to bring active equity ETFs to market.
They did however approve the idea of Exchange Traded Managed Funds for active ETFs that combines the features of ETFs and mutual funds. These ETMFs allow you to bid to buy a unit of a fund at the end of day closing net asset value. To me at least, that sounds like a complicated way of buying a traditional mutual fund, rather than a revolutionary break through and I am not sure it will be a long term winner, although there are tax advantages to US owners.
In the meantime, active ETFs may continue to be a backwater or, to be kind, a specialist niche. They may be growing rapidly, but off a very low base. It will take a willingness by active portfolio managers to loosen up a bit about disclosing their positions and it will take a greater marketing effort by the ETF issuers and their active colleagues to really get active ETFs into the mainstream.
Peter Sleep is a senior investment manager at Seven Investment Management (7IM)