Active ETFs produce few stars and even fewer fans

Mutual fund firms move defensively toward active ETFs

Jul 28, 2016 @ 8:18 am

By Jeff Benjamin

Actively managed exchange-traded funds continue to represent one of the unsolved mysteries of the asset management industry.

It is an incarnation that is less than a decade old that includes some glowing success stories, a general reluctance from most mutual fund managers to get on board, and an arm's-length circumspection from the financial advice community.

“It has been an interesting corner of the market, and we haven't seen the traditional fund industry really come in and play ball yet,” said Dave Nadig, vice president and director ETF research at FactSet Research Systems.

Morningstar counts 156 actively managed ETFs, with the first ones launched in 2008, and 24 launched this year. But the overall category at about $26 billion still represents only about 1% over the overall ETF space.

Much of the active ETF universe is loaded up in a handful of home-run hitters, including the $2.7 billion SPDR DoubleLine Total Return Tactical ETF (TOTL), the $2.6 billion Pimco Total Return Active ETF (BOND), and the $4.5 billion Pimco Enhanced Short Maturity Active ETF (MINT).

The only other active ETFs to have crested the billion-dollar mark are the $1.3 billion First Trust North American Energy Infrastructure ETF (EMLP), and the $2 billion iShares Short Maturity Bond ETF (NEAR).

The main distinction between active and passive or index-based ETFs is that the underlying holdings in the active ETFs are dynamic and managed similar to the way a mutual fund portfolio is managed.

But, unlike a mutual fund, which will disclose portfolio positions quarterly, the active ETFs is required to disclose positions daily, just like a passive ETF.

The portfolio disclosure rule is often cited among mutual fund firms as the major sticking point preventing them from entering the active ETF space.

The success of the Pimco and DoubleLine products is often attributed to the solid brand name of the managers, but there is also something to be said for the specific strategies, according to Dave Mazza, head of ETF and mutual fund research at State Street Global Advisors, which contracted with DoubleLine's Jeffrey Gundlach to manage TOTL.

“In the case of TOTL, the strategy is a bit different than the well-known DoubleLine flagship Total Return mutual fund, but the reputation of the portfolio manager probably helped the ETF gain assets,” Mr. Mazza said.

Understanding the focus by financial advisers on fund track records, Mr. Mazza acknowledges the rare success of TOTL growing to become the second largest active ETF just 17 months after its launch.

He is also familiar with the reality of challenges faced by active ETFs like the SPDR SSgA Multi-Asset Real Return ETF (RLY), which is part of a suite of ETFs of ETFs launched in 2012 that has attracted just $84 million.

“The funds that have truly grown have done so because they are offering something you can't get in a mutual fund, or at a better price point,” Mr. Mazza said.

TRANSPARENCY

Many of the active ETFs that are offered by firms that have similar mutual fund strategies will be priced in the range of institutional share class mutual funds in an effort to prevent cannibalizing business lines.

Mr. Nadig of FactSet said the mutual fund industry-fee challenge is only one of the hurdles it needs to address when getting into the active ETF space.

“You need to convince the distribution channel they can live without 12b-1 fees, and they need to convince the portfolio managers to be comfortable with portfolio transparency,” he said of the requirement that active ETFs provide a level of portfolio transparency that is much more detailed than is the requirement applied to a mutual fund portfolio.

While brand names can usually be counted on to boost sales, it is not automatic, as illustrated by the humble success of three active ETFs launched in October 2014 by Fidelity Investments.

Fidelity Total Bond (FBND) has $182 million, Fidelity Limited Term Bond (FLTB) has $132 million, and Fidelity Corporate Bond (FCOR) has $35.7 million.

FIDELITY

Investors and advisers might be cautious about the shorter track records, but the performance of many of the funds is sound.

FCOR, for example, is up 9.7% from the start of the year, which compares to a 5.4% gain this year for the Barclays US Aggregate Bond Index.

Fidelity declined an interview request for this story, but spokesperson Nicole Goodnow responded in an email noting that “while we continue to evaluate the product needs of our clients, it would be premature to discuss our plans at this time.”

“Our goal, as always, is to provide our clients with a variety of products/solutions to choose from to help meet their specific financial goals,” Ms. Goodnow added. “As a result, we have already moved forward and launched three actively managed transparent fixed income ETFs.”

Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, said active ETFs face the dual challenge of swimming against the current of a movement toward passive investing strategies, and the growing popularity of smart beta ETFs, which straddle the line between active and passive ETFs.

“Smart beta is gathering assets and, I think, taking some of the flows from active ETFs,” he said.

So far, the majority of active ETFs have focused on fixed income strategies, but that might change with a more streamlined approval process by the Securities and Exchange Commission.

BIG HURDLE

The change in the approval process, announced earlier this month, could reduce the time it takes to launch an active ETF by two-thirds to about a month, according to Mr. Nadig.

Regardless of how many active ETFs come to market, there might still be the bigger hurdle of getting support from financial advisers.

Michael Kitces, director of research at Pinnacle Advisory Group, said active ETFs are not gaining traction from advisers because they take away part of an adviser's value proposition.

The advent of low-cost retail brokerage platforms has taught investors that “anybody can pick a mutual fund,” Mr. Kitces said.

With that in mind, he believes more advisers will be steering clear of active funds in general that are doing the work financial advisers can and should be doing.

“Even if they're cheaper, and they're using the ETF structure, there are a growing number of advisers that don't want to outsource that part of the value chain anymore,” Mr. Kitces added.

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