ACTIVE ETFs: The importance of being active

SnowboarderSome big-name fund managers are experimenting with active ETFs. But can they convince the sceptics who say this kind of product should only be used for passive index-tracking? George Mitton finds out more. Many investors think of ETFs as tax-efficient, transparent funds that provide daily liquidity and offer a cheap, convenient way to track benchmarks such as the Standard & Poor’s 500. In other words, they think of them as passive instruments for generating beta returns. This is the ETF concept: reliable, cost-efficient, simple to understand. And yet, providers of active ETFs seek to challenge this orthodoxy. They say, why not combine the ETF format with the skills of active managers? Why not combine the transparency, low costs and liquidity of an ETF with the market insight and stock-picking talents of managers who can beat benchmarks and generate alpha returns? It is becoming more and more difficult to dismiss this idea as a fringe or novelty product. Pimco’s Bill Gross, one of the most respected bond managers in the industry, filed for permission in April to launch an ETF version of the Pimco Total Return Fund. Many say more big-name managers will follow suit. And yet, there is considerable wariness among investors and a good dose of scepticism in the industry. The problem is that the concept appears to go against most people’s understanding of an ETF, which is as an instrument that passively tracks an index. Is the idea of an active ETF a contradiction in terms? Ted Hood, chief executive officer of active ETF firm Source, thinks not. “An ETF is nothing more than a conventional, ‘plain vanilla’ mutual fund that has some additional attributes,” he says. “The ability to control your execution, to have complete transparency on your investment, to manage your investment like a security, from a back-office perspective; there’s nothing about that which suggests you should only use it for passive replication of a traditional benchmark.” (For more from Ted Hood, see interview on pages 16-17.) The situation can be confusing to investors because the term “active ETF” is applied to a range of different strategies. The most active products work like a mutual fund and are overseen by a portfolio manager who trades regularly. United States-based active ETF provider AdvisorShares offers a number of these products. But there are other, softer forms of active ETFs which combine elements of active management while still functioning as index-tracking products. Source has developed an ETF with Man GLG that does this. The ETF passively tracks an index, just like a traditional ETF; however, the index it tracks was created by Man GLG according to a specific investment strategy and changes more rapidly than a traditional index. Sandy Rattray, head of the Man systematic strategies group at Man GLG, says his firm could have distributed the product as a standard Ucits III fund, but saw that the strategy it used was suited to building an index. Man GLG sends instructions about what should be added or deleted from the index to a third party, which calculates the index. The firm licenses the index to Source. But though the ETF itself is a passive tracking tool, Rattray insists the product generates alpha returns. “It’s an actively managed index, which outperforms passively managed indices such as the MSCI Europe or the Stock 600,” he says. Although Source and Man GLG are confident that their product can attract big inflows and generate good returns, there are those who doubt whether active ETFs have a future. Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock, is particularly dubious about the fully active products. “I don’t think active products in a concentrated stock-picking way will be successful because I don’t think that’s what people look for,” she says. “Investors are using ETFs to equitise cash, as a core, as a satellite, to build portfolios; they’re using them because they’re looking for products that track a benchmark. They’re not looking for alpha.” The more an ETF apes the characteristics of an active fund, the more it surrenders the advantages it possesses in light of being an ETF, according to Fuhr. If a fund is very active in trading, it will become less tax efficient than a traditional ETF, for instance. Another problem is that actively managed ETFs might not appeal to some of the most enthusiastic users of index tracking ETFs: that is, the fund managers. “The challenge is going to be, who is going to use the product?” asks Fuhr. “Definitely not an active portfolio manager who today uses ETFs to equitise cash because, if you’re an active manager, would you actually invest in someone else’s fund? No.” Fuhr believes that some active ETFs could succeed, but they will be those, like the Source-Man GLG product, which track an actively managed index, rather than those which do concentrated stock-picking like an active manager. The transparency question
Another potential problem with applying ETF characteristics to actively managed funds is that this practice may expose fund managers’ investment strategies. Many fund managers say they do not want to provide daily transparency on their portfolios as this would give away their positions, allowing others to copy them. This, at least, is the theory. But is this a genuine obstacle or could it be, as some claim, an excuse that fund managers give to avoid adapting to change? Many of the companies running active ETFs say their strategies are too large and intricate for anyone to replicate. This means there is no danger in revealing the funds’ contents. Philip Poelzl is co-founder of Qbasis, a hedge fund which manages a futures-based active ETF. He says: “We don’t have a problem with transparency… we trade on more than 100 different futures markets, and we trade on the futures markets with different strategies. It’s very difficult, even if somebody could exactly analyse what we are doing, to really get a full concept of our trading strategy.” He adds: “There’s not really a probability for someone to copy the system because in many details it’s just too complex.”
Alan Miller is the founder of SCM Private, which actively manages a portfolio of conventional, passive ETFs. He is even more strident on the issue of transparency and claims the idea that individuals are liable to copy fund managers’ strategies is “absolute total and utter nonsense”. He says: “What is the chance of the individual copying all 110 stocks and getting a broker and deciding to copy that every single day and every time a transaction changes? Of course people are not going to do it.” But if the chances of individuals copying stock positions is so small, why not provide more transparency? Miller believes resistance in the industry is holding back innovation, with complacent fund managers continuing to insist that they can only provide infrequent and incomplete updates on the contents of their funds simply because it suits them. He describes this system as “bizarre and, I think, contemptible”. Miller believes fund managers could easily provide transparency without compromising their strategies, and holds that investors
deserve this added transparency. Those who agree with him could find active ETFs a very appealing proposition as they provide transparency while still harnessing the potential for an active manager to beat an index. Not even the most fervent proponents of active ETFs believe that all funds should be organised as such. Source has pioneered the concept but Hood accepts that the model is not always appropriate. “If it’s not sensible from an investment perspective to disclose the constituents of the portfolio, then you don’t want to do it as an ETF. For example, if you take very large or illiquid positions you may not want to disclose them,” he says. There are other questions to ask, such as, will investors appreciate being able to trade at a price and time of day of their choice? If the answer is no, there may be no benefit in organising the fund as an ETF. Defining active
Other potential hurdles could be attracting institutional investors as many of these need to see assets over a certain size and a three-year track record before they invest. Unless active ETFs attract these kind of investors they will remain a retail product, which will not please brokers, who want to see products that trade regularly and in large sizes. It may be that the debate on active ETFs focuses on the question of what “active” means in this context. There is clearly a big difference between a product overseen by an active fund manager, who picks stocks and trades on a daily basis, and one that tracks an actively managed index whose managers revise the index periodically. Investors who are wary of the concept of active ETFs are more likely to experiment with the latter, which suggests these are a good place to start.
Whatever happens, active ETF firms should get used to the idea that their products may only take up a small portion of the ETF market. After all, many users of these products choose ETFs simply because they are index-tracking tools and no more. Investors who are looking for a quick and convenient way to equitise cash are likely to continue to use traditional ETF instruments. However, the benefits of the ETF format are clear – this is why inflows into ETFs continue to grow. Investors want the transparency and daily liquidity that ETFs provide and in future fund managers may feel more pressure to give these to investors. An active ETF format may be the most convenient way to satisfy this investor need. ©2011 funds europe

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