May 2013


AnalyticsPerforce, I must begin with a confession. I do not understand what active exchange-traded funds (ETFs) are – and I never have. If the definition of an ETF is – and I’m quoting Investopedia here – “a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange”, how can it be active? People more knowledgeable than me have on occasion expressed similar doubts. Some were people who ran ETFs. Nonetheless, active ETFs are from time to time touted as the Next Big Thing that will revolutionise all other things. One of those times is now. SEI has just released a paper about it which suggests that “with investor demand increasing and regulatory guidance improving, opportunities exist for actively managed ETFs to explode”. A troubling thought, as we still don’t know what actively managed ETFs are. At least, I don’t. I turned to the web site of Pimco, an organisation that certainly cannot be accused of not knowing its onions. It is responsible for the largest active ETF in the US market, the Pimco Total Return ETF – an ETF version of the mutual fund of the same name. How does Pimco define actively managed ETFs? “No differently than we define actively managed mutual funds. From a portfolio management perspective there is really no difference in managing an active ETF other than certain requirements specific to the ETF vehicle, such as daily holdings disclosure,” it claims. What, then, are the benefits of actively managed ETFs? Pimco lists them as liquidity, pricing and trading, transparency and tax management. The Book of Love, as the lyricist Stephin Merritt tells us, is long and boring, and so is the explanation of why ETFs are liquid. It is beyond my puny powers to dispute it. I have one question. Are mutual funds not liquid? The other benefits of actively managed ETFs are foggy and uncompelling. Take tax management. SEI explains the tax benefits thus: “Because of the ETF’s unique structure, and the ability of an ETF manager to accommodate investment inflows and outflows by creating or redeeming ‘creation units’, taxable events occur less frequently in a conventional ETF structure than in a mutual fund. This has the effect of potentially benefitting shareholders to substantially decrease capital gains distributions.” The key word there, I think, is potentially. As for trading, it’s thrilling to learn from SEI that it is possible to trade actively managed ETFs “throughout the day on an exchange”. But I’m struggling to understand why the average investor would want to do that. I thought actively managed funds were a long-term investment. Neither is the cost of actively managed ETFs particularly low. “This active management comes at a cost,” says SEI, and the average expense ratio is 1%. In any case, we all know that you get what you pay for. That leaves transparency. ETFs are more transparent than mutual funds because they have to disclose their underlying basket of securities daily. It will not have escaped your notice that the biggest actively managed ETF in the US is a bond fund. There is a reason for that. Active equity managers are reluctant to disclose their holdings daily in case investors or competitors ape what they are doing without paying them. Replicating fixed-income strategies is more difficult, and so most active ETFs invest in bonds. How can this be solved? The SEI report states by “trying to find ways to work around the transparency rules and limit their disclosures of holdings.” Active ETFs will then probably be as about transparent as, eh, mutual funds. As SEI points out in its report: “The asset management industry is one founded on innovation and ingenuity.” Rather than putting that energy into coming up with whizzy new structures that in practical terms are not that different from the ones we already have, would it not be better to put it into managing investments? ©2013 funds europe

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