Active ETFs may boost closet indexers

So-called closet indexers have gotten a lot of flak over the past few years, but actively managed exchange-traded funds could be the best thing ever to happen to them. Closet indexers — those active portfolio managers who by design don't deviate much from their benchmark — have been scrutinized increasingly as low-cost index products have grown in popularity. The argument usually hinges on the question of why one should pay an active-management fee of typically about 1% for returns that will mimic an index that can be bought for less than 10 basis points.

HURTING ALPHA

These portfolio managers originally gained steam in the 1990s with the institutional crowd, who were looking for an index return with about 50 to 100 basis points of alpha, said Scott Burns, director of fund research for North America at Morningstar Inc. In other words, they aren't trying to shoot the lights out. The problem that the funds have always run into is that the fees they charge typically eat away any alpha they create. Fees are one of the big reasons that just 25% of all actively managed domestic equity funds beat their respective benchmark over the three-year period ended Dec. 31, according to Standard and Poor's. That is where actively managed ETFs come in, Mr. Burns said. Fees for actively managed ETFs have settled in between the retail and institutional mutual fund share classes, making the hurdle for beating an index much lower. Investing in active ETFs also sidesteps 12(b)-1 fees, sales load charges and fees to get on different mutual fund platforms, all of which boost the individual shareholder's performance investing in the fund. “They need every basis point they can get,” Mr. Burns said. It could very well take a while to see if the lower fees in actively managed ETFs pay off for investors, mainly because traditional mutual fund companies are taking their time bringing out the products. Stock-picking powerhouses such as Fidelity Investments, Franklin Resources Inc. and T. Rowe Price Group Inc. all have filed with the Securities and Exchange Commission to offer actively managed ETFs, but none has pulled the trigger yet. Active ETFs are still viewed by many as a question of when, not if. A recent report by McKinsey & Co. predicts that assets in actively managed ETFs will explode to $500 billion by 2020, up from about $15 billion today.