Are ‘active’ ETFs the answer?

7th September 2011

Exchange traded funds – ETFs – have been around for more than a decade, with the low cost vehicles growing to a $1.7trillion industry.

In the past, ETFs have always been passive, recreating a known asset basket such as an equity index or sector, or a representative spread of bonds.

Advisers who believe active management – stock selection and buy and sell timing decisions – is not worthwhile, use ETFs as a bargain basement investment tool for no-frills portfolios.

But now ETFs are going active with a number picking assets just like managers of unit trusts, investment trusts or American mutual funds.

So far, it's tiny – active ETFs add up to under 1% of all ETFs, while the 2,000 or so passive ETFs are only an eighth of the US mutual fund universe. In the UK ETF penetration is lower.

Those active numbers are set to rise dramatically, however, according to a recent report by management consultants McKinsey & Co which predicts the active variety hitting a trillion dollars within a decade.

If right, then managers researching, taking risks, and trading, could use the ETF format. And US investment techniques almost always cross the Atlantic.

What are the differences between ETFs and OEICs (unit trusts)?

An OEIC takes money in and invests it according to what it says on the tin. An ETF offers the tin first and then buys enough underlying shares or derivatives to satisfy holders.

An OEIC can only be traded once or twice a day – sometimes less often – while ETFs can be traded any time in exchange hours. ETFs can offer flexible strategies such as going "short" where investors hope to profit from falling prices. This is impossible with an OEIC. ETFs can be created around commodities such as oil or gold or property as well as stocks and shares. OEICs cannot.

Investors can buy just one ETF share but OEICs come with minimum investment levels. OEICs can come with automatic dividend reinvestment but ETF dividends are paid into your dealing fund so you have to make a positive decision to reinvest.

But for many, ETFs score on charges that are generally lower than OEICs, thanks to a mix of regulatory, tax, (depending on which country you live in) and marketing advantages.

How do active ETFs work?

As long as ETFs only adopted passive strategies (or replicated commodity prices) then there was little crossover into OEICs or mutual funds. But active is what is says – real managers making real decisions in real time.

This costs more than passive investments so active ETFs could lose cost advantages. Active ETFs could incur higher marketing expenses as a fund has to tell investors of its progress.

Current ETF rules insist on transparency – managers must reveal the contents of each fund on a daily basis. With passive or commodity strategies, that is rarely important. A FTSE 100 fund will contain the constituents of this index in their correct proportions – an oil ETF based on Brent crude will be 100% invested in just that.

But transparency does not always sit easily with active investment. Outside of regular statutory reports (every six months in the UK), managers may not wish the world to know what they are buying or selling.

This is to prevent "front-running" where other investors attempt to profit from the actions of fund managers known to be successful by forcing up (or down) shares that the fund is buying or selling – it also prevents rival fund managers from stealing ideas.

So far, active ETFs are a tiny drop in the ocean – one recent estimate put their combined size at a paltry $250m – half of this in one money market fund.

But if they can get over the transparency issue (and funds are working on that) then active ETFs could score on cost and flexibility grounds.

It's watch this space but the acid test could be when a leading US actively managed mutual fund turns itself into an active ETF.

Sign up for our free email newsletter here, for your chance to win an iPad 2.  

Leave a Reply

Your email address will not be published. Required fields are marked *