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What’s holding back the development of active ETFs?
May 20, 2014 @ 12:00 am
Todd Rosenbluth and Stephen Clarke discuss the biggest factors holding back the spread of active ETFs, as well as advisers' biggest concerns around these funds.
[MUSIC] The debate over active ETFs is really heating up, especially in the area of transparency, or lack thereof. Welcome back to The ETF Exchange. Today, we're joined by Stephen Clarke. President of Navigate Fund Solutions an Eaton Vance company and Todd Rosenbluth director of ETF and mutual fund research at SNP Capital IQ. Together, we're gonna dig into this question of transparency and find out really what's holding back managers from launching more active ETFs. Thanks for joining us gentlemen. Todd I want to start with you and ask you what do you think is holding back the development of active ETFs? Yeah I think for an advisor or an investor who's choosing an ETF, they're choosing in a way, from an actively managed mutual fund. And what they get with an ETF typically, is a lower expense ratio. They get liquidity. They get intraday. Opportunities to get in and get out of the portfolio were tactical, or not. And they're deciding that they don't wanna take the chance that an active management is gonna fail to outperform, as many mutual funds tend to do. If there's an active fund, you typically wanna see a track record. And it's a bit of a chicken and egg situation. You need to see performance but, before you go in there. But it, something needs to have scale before investors will actually want to go back into it. So, that's the challenge I think. Okay. And Stephen, what's your perspective on that issue of the development of active ETFs? So, looking at it from the, the perspective of an active manager who's interested in, in the performance improvement or the better performance and, and Structural efficiencies of the ETF. the, the primary impediment to adopting the ETF structure has been the requirement for daily transparency. And the reason for that there a few reasons, but the primary reason is because if a portfolio's disclosed to the market every morning. There's the potential for other market participants to dilute the returns. You're delivering to your clients through, through front line trades. Okay. And so, on this issue of transparency, which is really the crux of where we wanna get to today. Todd, what's your sense of why transparency in this realm is, is so important? Well, specifically for an advisor that's looking to put an ETF into an asset allocation approach,. You wanna know that something is large cap growth, is large cap value. It is short term fixed income. And know that it's always gonna be there. So, transparency in daily holdings is specifically important for an adviser to put something into an asset allocation bucket. And for us at S and P Capital I.Q. to do research on that, we need to know what's inside the portfolio. Because, of course, not all large cap growth. Actively manage funds, or even passive ETFs, are anything alike. There's a lot of differences between them, so transparency helps us to understand, and for investors to understand what's really going on inside the portfolio. Okay, but there are issues for, for the managers. And Stephen, I wonder if you could lead us through some of those issues. Like why transparency is kind of a hurdle for, for mutual fund managers who are perhaps thinking about, you know, an active ETF would be a good product, but I've got this transparency. What are the problems that they're facing? Sure, with the, with the product that we're developing, as you might imagine, we speak to a great many portfolio managers about this. And, and what, what active managers tells us is that there are really three, three impediments to. To adopting the, the more efficient ETF structure. The first one is, is, is the, the fear of front-running [INAUDIBLE] And that's the most important, but the other two are, are also important and they're more commercial considerations. One is them is if a portfolio manager is providing their, their, their intellectual property, their portfolio, to the market place every morning. Other market participants could, could use that information to replicate their portfolio without, without compensating the manager. And then the third one is maybe a little bit more subtle but for, for many managers is, is, is equally important. And that is, is if you're providing your portfolio holdings into the market place every morning, you're also giving real time research insights to your competitors that, that could result in. Diminishing of your opportunity to deliver value to the clients. Okay. In the work that you do, Todd, I mean do those reasons resonate or there other things that you see as, as perhaps, kind of those, those road blocks or does that make sense to you? Well, I think that other reason is out there is cannibalization, you know, a mutual fund company. Charges a higher fee typically for an actively managed mutual fund than what's out there for the passively managed ETF benchmark. And so to launch a bench, launch an ETF and giving away information that is cheaper than their actively managed mutual fund. If they actually are successful, they're actually going to bring their profit margins perhaps down as a result of it. But that said. Actively managed mutual funds up until this year have been losing share, and in fact they still are losing share to the passively managed equity ETFs. Money is moving into ETFs for that low-cost reason, for that liquidity, and perhaps for that transparency. And so it's not surprising that a mutual fund company might want to explore a way to offset that bleeding by getting into that space. Cannibalization. Is that something that you hear in your discussions, Stephen? It, it, it's not. I think what, what active fund managers are interested in is, is finding a way to access the performance advantages and tax efficiency of the ETF structure in a way that doesn't compromise daily portfolio trading or portfolio trading strategies. And, and that's the feedback we get from active managers. In terms of cannibalization if, if an active manager can deliver their, their capabilities in a, in a better performing, more efficient vehicle, I think they're going to be anxious to do that as long as they can do it in a way that is not hurtful to the investors they've been, they've been hired to, to protect. Okay. There are active ETFs out there on the marketplace. So there are managers who have overcome. This issue of transparency, how do you think that they've managed to work through those issues that you've raised Steven? So that, that's true in certain asset classes. There have been, there have been some managers that have adopted the active fully transparent ETF structure. And those managers would have needed to, to the extent that they're an established manager offering their capabilities to other investors in other funds and other structures But they would've needed to have reached the conclusion that that delivering their portfolio to the marketplace every morning in a transparent way. isn't, isn't hurtful to the investors in that fund, or any other investors that, where they're managing a portfolio in, in the same approach. So they would need to reach those conclusions in order to adopt the structure. And what we've seen actually, if I may, is that some of the actively managed companies have done partnerships with traditional UTF providers. So we've seen, you know MFS get together with State Street and launch an active products earlier this year. So they're using MFS research tools. State Street is providing the ETF wrapper that's there. TCW launched emerging market fixed income products with EG shares. So TCW is again providing the intellectual property behind it. EG Shares is providing the wrapper and the infrastructure to be able to deliver it, because, it's a lot harder for M, we think, for MFS to wanna go and launch their own products that may again, we think, cannibalize what they're currently doing in the space, so they've gone into something else that they don't have as popular mutual fund product. Right. Following that same quantitative tools. Okay and so the industry is obviously trying to work its way through and figure out ways to, to get around or work with these, these requirements if you will. And that's one of the things that you're working on Stephen. finally, really quick, tell us a little bit about what you've been working on in terms of coming up with a product that has an ETF not quite actively managed, but you're, you're again trying to come up with something that delivers that active performance but doesn't have that daily transparency. disclosure, right? So, we are, we are currently developing a product concept we call the exchange-traded managed fund or ETMF. Which would be 40 act structure that would work for a broad range of, of active strategies. That would have the performance advantages and tax efficiencies of the ETF without requiring daily portfolio holder's disclosure. It's currently is an active file under consideration at the SEC. So, I can't see a lot more about that. But we're, we are working to, to endeavor to bring that product to market. Okay. And, and again, the, there are several fund companies that have products and registrations go to the SCC, so I guess for viewers here to keep their eyes open and see what comes out of the SCC as they approve or don't approve and seek other requirements from the space. So, clearly active ETFs is a business that is growing and so I guess keep their eyes open, right? Gentlemen, thanks for joining us today. Thank you. Thank you. [MUSIC]