The not-so-hidden drawback to active ETFs

With almost $2 trillion in assets, exchange-traded funds have become important components of many institutional and retail portfolios. The vast majority of those ETF assets — more than $1.9 trillion — are invested in passively managed exchange-traded funds that track a particular index. Less than $20 billion are in actively managed ETFs, in which managers use their skills to potentially outperform an index.

Despite all the advantages of the exchange-traded fund structure — lower costs and greater tax efficiency, for example — why have actively managed ETFs attracted such a small slice of the overall ETF pie and an even tinier share of the $11.5 trillion invested in actively managed mutual funds?

The answer lies in the inherent contradictions of housing active management in an ETF structure.

In a conventional, open-end mutual fund, managers disclose their positions quarterly, enabling them to buy and sell shares carefully on behalf of investors without revealing their strategy to other market participants through day-to-day trading activity.

In an exchange-traded fund, by contrast, the fund’s component securities must be disclosed daily In order for exchange market-makers to do their job of efficiently keeping the price of the ETF in sync with the prices of its components. In index ETFs, of course, the components are known to all and rarely change. Ironically, however, the disclosure that has made passively-managed ETFs so successful works to the detriment of investors when active management takes place within an ETF.

When active ETF managers disclose their daily holdings they effectively “tip their hand” to professional traders and other market participants, signaling through the portfolio changes that result from their thoughtful buying and selling in the marketplace the direction of their trading. Acting on those signals, market professionals can buy or sell those securities ahead of the active ETF manager, thereby seizing profit opportunities that would otherwise accrue to the fund’s investors. Other market participants can simply follow what the active ETF manager is doing, effectively creating a passive fund that “free rides” on the research and intellectual capital of the active manager without paying for it — earning the returns of the active ETF without many of its costs.

Because of these shortcomings, few active managers have chosen to pursue their investment strategies within the active ETF structure. But a new form of exchange-traded managed fund has been created and approved by the Securities and Exchange Commission that combines elements of ETFs and mutual funds in a way that is conducive to active management.

Funds using the new structure, NextShares, can be bought and sold throughout the trading day like an ETF, but are valued at the end of the day based on the net asset value (NAV) of its components, like a mutual fund. For investors, the price of NextShares trades will equal the fund’s next end-of-day per-share NAV, plus or minus a premium or discount determined in the market when the order executes. For example, a NextShares trade executed intraday at NAV +$0.02 will have a final price of $20.02 if the fund’s NAV at the end of that day is $20.00. This new trading method, called “NAV-based trading,” is the key innovation underlying NextShares. Since the prices of NextShares are determined once a day, they are intended for those who want a long-term investment, not a short-term trading vehicle.

Because exchange market-makers don’t have to keep NextShare prices aligned with the prices of their component securities throughout the trading day, NextShares do not have to disclose their holdings daily. As a result, NextShares allow active managers to pursue their strategies on behalf of fund investors without having to worry about other market participants profiting at their expense. This removes the impediment that has kept active managers from offering ETF versions of their funds.

Through NextShares, investors finally will be able to benefit from having access to the active management strategies now available in mutual funds in a structure that provides the economies and tax efficiencies of exchange-traded funds. NextShares delivers on the promise of actively managed ETFs.