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Exchange-traded funds are investments that trade shares of a basket of securities that’s almost always based on an underlying index. The funds have two classes of participants: retail traders who buy and sell shares as they would any other security, and “authorized participants,” which are investment companies that buy and sell the underlying securities to create new retail ETF shares and maintain parity between the fund’s net asset value and its market price. ETFs tend to have lower expense ratios than mutual funds and they give investors greater control over the timing of capital gains.
“The traditional idea behind ETFs wasn’t to provide a more efficient index fund,” says Gary Gastineau, author of The Exchange-Traded Funds Manual
(Wiley, 2010). “It was to provide trading on the floors of the American and Toronto Stock Exchanges.” In the process, he says, the funds became a superior product for long-term investors. The Active ETF Alternative
Almost all ETFs are managed to mimic the performance of some index. Morningstar reports that of the $1 trillion in ETF assets, $50 billion are in funds that aren’t market-weighted and $2 billion are in actively managed funds. In other words, there are fewer ETF assets with an element of active management than in the largest ETF alone. This may change; recent filings by some major money-management firms indicate that active funds could be a growing part of the market.
As it is, some passive funds have elements of active management. For example, funds based on commodities indexes use futures contracts, which aren’t buy-and-hold assets. Many funds are based on market niches that aren’t tracked by the recognized market indexes; instead, the management company creates an index, often using active management principles. Todd Rosenbluth, an ETF analyst with S&P Capital IQ, says that ETFs on invented indexes may seem a bit like actively managed funds, but they still follow the rules of passive investing: The created index is stated in advance and the ETF is managed to it, even if there’s less data on it than on the Standard & Poor’s 500 index.
Many ETFs use tactical management to allocate within an index, changing the weighting but not the securities used. These are intermediates between active and passive that take advantage of the feature of ETFs that benefits active managers the most: control over cash flow. In a typical actively managed account, a manager may need to sell securities to meet redemption orders or buy assets at inflated prices to put new cash investments to work, upsetting the portfolio’s structure. There’s always a small portion of cash on hand, which can drag down returns. With an ETF, the authorized participants create new shares by contributing securities, not cash, keeping the portfolio in alignment.
Active ETFs have problems, though: In an actively traded fund, the positions change during the day. That makes it difficult to determine the exact price of the fund at any given time, because the position sizes will vary along with the prices. The premise of ETFs is that active traders can buy or sell, in cash or margin, to take advantage of intraday movements. If the pricing isn’t good, then trading opportunities are limited.
Investors seem more accepting of this discrepancy in funds that trade illiquid securities and in markets that have different hours from the New York Stock Exchange. No surprise that the two largest active fund issuers, PIMCO and WisdomTree, specialize in fixed-income and emerging-markets funds that deal in relatively illiquid securities that aren’t necessarily traded during NYSE hours. Also, the indexes in these markets aren’t as widely followed, creating an opening for people who offer an alternative.
The largest actively managed ETF, PIMCO Enhanced Short Maturity Strategy, has attracted $1.8 billion in assets since its introduction in 2009. Although that represents almost all the actively managed ETF assets, the fund has achieved a nice size in a crowded market. Meanwhile, WisdomTree dominates the managed index market with 47 ETFs that are either actively managed or positioned relative to an index. The company has assets under management of $11 billion. Playing Follow the Leader
Actively managed funds attracted almost no assets until the PIMCO fund came out in 2009. PIMCO has filed for a new fund that’s likely to make active ETFs hot. It plans to launch an ETF version of the PIMCO Total Return Fund, the world’s largest mutual fund with $244 billion in assets. Other active money managers watching asset flows are asking one question: If PIMCO can do it, why can’t we? “When a big company like PIMCO offers its flagship strategy in ETF format, then you know actively managed ETFs have arrived,” says Samuel Lee, an ETF analyst at Morningstar.
Although traders may like index ETFs, not all ETF buyers are traders. Over the years, “there’s been a fundamental shift in how financial advisers invest,” says Jim Wiandt, founder and CEO of IndexUniverse, which tracks the sector. In the past, they’d place client funds in individual stocks or with active money managers, but now they’re likely to use ETFs to do tactical asset allocation. They’re attracted by ETFs’ low-cost structure and tax advantages, although active ETFs have higher expense ratios and will have larger capital gains than indexed products.
Nevertheless, the mutual fund market is so crowded that fund families may turn to ETFs to bring in new revenues. Many ETF fund sponsors also have active-management divisions and the mutual fund companies that have been entering the market are mostly active managers. “They want to be in the game and not get left behind,” Rosenbluth says.
Money management firms don’t want to lose customer money to competing products, but most have shown little interest in ETFs. Management fees are lower and indexed products carry few opportunities for firms to add value. If actively managed ETFs take off, though, mutual fund companies will have to go where the money is. For most, it’ll be a cultural change. “For retail-focused mutual fund companies, going to an ETF structure represents a disintermediation of their customer base,” Wiandt says. No longer will spending on customer-friendly websites attract investors, nor will huge databases of customer information have much value. Unless the fund sponsor also has a discount brokerage service, it won’t even be able to execute orders on its ETFs.
Rosenbluth notes another risk for active managers: Having ETF versions of signature funds would increase transparency for the money managers’ strategies. Fund holdings would have to be announced daily for the authorized participants instead of quarterly. That means they may be tipping their hands to the market about strategic changes, inviting competition and front-running of their trades.
On the other hand, actively managed ETFs are more complicated products than index ETFs, so they’ll have to be sold to investors. The proposition has been simple: Want to buy the S&P 500? Then buy the S&P 500 SPDR on the index. But a total return bond fund structured as an ETF? “It’s tougher to sell a strategy than it is an asset class,” Wiandt says, but the PIMCO brand name and track record carry clout. Given that the mass-market mutual fund companies are very good at marketing, they may be better able to attract assets to ETFs than those who have gone before.Issues Requiring Innovation
The move to actively managed ETFs is likely to bring some big changes to the sector, as these investments may have to be structured differently from indexed ETFs to address pricing to a trader’s satisfaction.
Active ETFs don’t have static portfolios based on indexes that continually track asset prices, and only the manager knows for sure what trades are placed during the day. “The less transparency and liquidity you have in a fund, the bigger the spreads,” Wiandt says.
On the other hand, he notes that the active trading in ETFs has often helped establish prices in less-liquid markets. Actively managed ETFs are less likely to be used by day-traders, high- frequency traders and other active participants, which means they may have less liquidity and larger spreads than the traditional products. That doesn’t make them bad, but they don’t share the standard ETF story line.
In fact, because NAVs are calculated at the end of the trading day in New York, even ETFs on standard indexes may not be accurate because of after-hours trading and activity in international markets. (That was the genesis of the front-running scandal that snagged some mutual fund companies in 2003.)
ETFs are priced at market value, but they’re traded on a bid-and-ask basis, which means that any given investor is likely to pay more than the NAV to buy and receive less when selling. At the time this is written, the NAV for the S&P 500 SPDR was $116 and the spread was $128.48 to $128.49. Even a fund like that has pricing discrepancies, although the effects are small for long-term investors.
As for what’s next in this market, in October 2011 Eaton Vance announced a new ETF division called Navigate Fund Solutions that will develop what it calls exchange-traded mutual funds. These would be actively traded funds structured as ETFs, but with an unusual pricing structure. Instead of orders being entered at the actual price, orders would be entered at the NAV plus or minus the spread that was in effect — a few cents, in most cases. Trades would clear whenever a matching order was placed. The lack of intraday pricing would give the portfolio managers some cover as they repositioned the fund assets while still allowing for intraday trading. If this idea is approved by the Securities and Exchange Commission, Eaton Vance plans to offer its own exchange-traded mutual funds and license the intellectual property for NAV-based trading.
“It’s interesting. It could work,” Wiandt says of NAV pricing. “It basically gives the space to have less-than-full transparency while having fair pricing.” But he points out that this is hardly the biggest concern of the SEC in the current market. Unlike mutual funds, it’s not easy to get a new ETF to market. The SEC still doesn’t have a formal application process for ETFs; funds actually file for exemptive relief from the Investment Company Act of 1940 rather than a standard offering document, and that makes startup expenses high, Morningstar’s Lee says.
It’s thus more economical for a large firm to get into the ETF business than a small one, and many of the large firms that offer ETFs entered the market through acquisition, a strategy that may be of interest to investors in publicly traded money management firms.
It’s anyone’s guess when or if the SEC will approve Eaton Vance’s proposal. It represents a major change in the way that ETF orders are placed and shares traded. It is, however, an opening salvo for active ETFs, addressing some of the concerns about the standard structure in order to bring attractive investments to the market.
The different asset management companies are working hard to find new ways to make the ETFs work for them. This means investors will see more ETF products with new features.
These changes will make ETFs more complicated. IndexUniverse’s Wiandt is concerned that problems with new products could sour people on the entire sector.
Still, the new ideas flowing into the ETF sector promise to make it interesting again, 19 years after the first ETF came to market.27 ETFs With a Return of at Least 15 Percent
The above 27 exchange-traded funds are those with a market-price return of at least 15 percent annually over the past three years. Morningstar calculates this figure by considering the change in the ETF’s market price and reinvesting all income and capital-gains distributions; this may differ from the ETF’s net asset value (NAV). We also sought five-year average earnings growth of at least 10 percent for the ETF’s holdings and an average price-to-fair-value ratio for the portfolio’s stocks covered by Morningstar analysts to be less than 1.0.
We’ve also provided the percentage of the portfolio assigned Moat ratings of “wide” or “narrow” by Morningstar. Moat refers to a company’s sustainable competitive advantage, such as a well-known brand, scale advantages or high barriers to entry. Finally, the expense ratio is detailed.
ETFs in this table and the rest of this article are mentioned only for educational purposes. No investment recommendations are intended. Data is from Morningstar as of Jan. 10, 2012.