Seven-year losing streak? Active stock ETFs could change the game

Expected lower fees would give stock pickers a leg up on index funds

Jan 15, 2013 @ 12:16 pm

By Jason Kephart

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Asset management firms beset by massive outflows from actively managed stock funds are lining up to join in on the exchange-traded fund fun. It's probably too late to make a dent on the passive side, but actively managed stock ETFs could be just what the industry needs to tip flows back toward stock pickers.

Last week, T. Rowe Price Group Inc. became the latest fund firm to gain approval from the Securities and Exchange Commission to launch actively managed ETFs. Fidelity Investments, Franklin Resources Inc., Legg Mason Inc., Janus Capital Group Inc. and Columbia Management Investment Advisers all are in various stages of working through the exemptive relief process with the SEC.

Most of the fund companies, including T. Rowe, already have laid out plans for active bond ETFs. Granted, only Columbia actually has filed for active stock ETFs, but given that most of these firms were built on stock picking, it's probably safe to assume they're at least being considered.

In fact, there's a very good reason for these fund giants to be considering active stock ETFs. Over the past seven years, investors have increasingly voted against actively managed stock mutual funds with their wallets.

That's not a typo. The last time active U.S. stock funds, as a group, had net inflows was back in 2005, according to Morningstar Inc.

That exodus has only gained momentum. Investors pulled a record $134 billion from active U.S. stock funds in 2012, topping 2008's $132 billion of net withdrawals, according to the mutual fund research firm.

Their passive counterparts, which include both index mutual funds and ETFs, have fared much better. Those funds have registered net inflows in each of the seven years that active funds have lost money. Last year, passive funds gathered $69 billion of new investments, a four year-high.

It's easy to conclude that in 2008, active management left a sour taste in investors' mouths. The average large-cap fund lost 40% that year, 3 percentage points worse than the S&P 500.

But Fran Kinniry, a principal in the investment strategy group at The Vanguard Group Inc., the largest provider of passive investments, says that's the wrong take-away.

“It's not about active versus passive,” Mr. Kinniry said in a recent interview. “It's about fees. We're in the early innings of prolonged lower returns. Costs really matter.”

The difference in the fees charged by active funds versus those of passive funds can be jarring. The average large-cap mutual fund, for example, has an expense ratio of 120 basis points, according to Morningstar. Several large-cap ETFs, spurred on by the white-hot ETF fee war, charge less than 10 basis points.

“The hurdle for delivering alpha has gotten higher,” Mr. Kinniry said.

That's where active ETFs come in. Pacific Investment Management Co. LLC already has laid out its blueprint for active ETF success — and it includes lower expense ratios. The Pimco Total Return ETF (BOND) has grown to almost $4 billion in less than a year. Yes, the fund does have the star wattage of Bill Gross, but it also has an expense ratio of 55 basis points, about one-third less than the mutual fund version.

If active stock ETFs had similarly lower fees, it could make a big difference in performance. The average large-cap fund, with its 110 extra basis points of fees, underperformed its comparable ETF by about 70 basis points last year, according to a Bank of America research note.

With fee cuts similar to Pimco's, the average active stock ETF could charge somewhere in the range of 80 basis points. With those cuts, a number of active managers would have generated benchmark-beating performance last year. Big fund shops like Fidelity and T. Rowe already have below average expenses on their stock funds — and theoretically could go even lower.

While that's no guarantee of performance, it's no surprise that managers who run funds with higher expenses will probably have a harder time outperforming over the long haul, said Michael Herbst, director of active fund research at Morningstar.

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