Active ETFs Wait for Their Heyday

A version of this article originally appeared in the October/November 2013 issue of Morningstar Advisor Magazine. To subscribe, please call 1-800-384-4000.

As a fan of the Chicago Cubs, I am all too familiar with the spring mantra: "This is our year." So, as someone who is also charged with analyzing the exchange-traded funds industry, I wince when I hear talk of the "year of the active ETF." Each of at least the past three years has been heralded as such by the financial media and industry watchers (including Morningstar). But there is no doubt that the active-ETF space has been long smoke and short fire with a few notable exceptions. I've examined the current crop of actively managed ETFs and highlight the characteristics that are hallmarks of a fund worthy of your investment.

The Appeal
It's easy to see why many have become a little enamored of the potential of these vehicles. Active ETFs give investors an efficient way to gain access to active investing strategies that can be cheaper and more transparent than open-end mutual funds. They're also very tradable.

But brand-name managers, aside from PIMCO, have been slow to climb aboard the supposed bandwagon. Managers who run concentrated equity portfolios, for example, are not keen to show their portfolios on a daily basis. Also, some managers are reluctant to operate in a vessel with no loads or redemption fees to buffer the costs associated with asset flows. Delivering an active strategy in an ETF would also take away managers' ability to close their funds to new investors at those times when their strategy has hit "capacity" or they don't see ample opportunity in their traditional fishing holes. After all, an ETF that is closed to new investors would essentially be a closed-end fund.

Despite these concerns, many firms are preparing to take the plunge. There are far more firms that have filed to launch active ETFs (35) than there are current providers of such funds (15) at the moment. Most of them are fixed-income funds, and many of these are of the very short-term variety. Because bonds are traded over the counter instead of on an exchange, fixed-income managers are less concerned with other investors front-running or shadowing their portfolios. Daily transparency is not much of a concern for them.

A Drop in the Bucket
Bear Stearns launched the first actively managed ETF in 2008. Called Bear Stearns Current Yield, it quickly closed that same year as the parent firm collapsed. Five years later, actively managed ETFs are still struggling to gain traction. As of August, there were 64 actively managed ETFs holding $14.4 billion in assets. That take represented a measly 1% of the total assets invested in exchange-traded products. Even more telling: 60% of actively managed ETF assets are in funds run by PIMCO. Indeed,  PIMCO Total Return ETF (BOND) alone accounts for about 30% of all active ETF assets.

Fund companies such as PIMCO have effectively used the ETF wrapper as a new means of distribution to deliver time-tested active strategies to the masses in a manner that reduces the cost of investing in them for a wide swath of investors. That's not always the case, though. Others such as  AdvisorShares Global Echo ETF seem keen to leverage the trendiness of the active ETF category as a way to market funds with unproven managers that wouldn't likely stand a chance in a traditional mutual fund format. Then, there are funds in the category that aren't really actively managed at all. For example,  WisdomTree Chinese Yuan is a single-currency fund that is classified by the Securities and Exchange Commission as an actively managed ETF largely on the basis of a technicality: It doesn't track an index.

Bigger, Cheaper Are (Generally) Better
The good news for investors is that it is very easy to discern among the good, the bad, and the "other" in the actively managed ETF universe as it stands today.

Looking at asset size is a good way to separate the wheat from the chaff in the current crop of active ETFs. Of the 64 active ETFs, just 18 have more than $100 million in assets. The $100 million figure is widely perceived to be the dividing line between a fund that is on its last legs and one that will have long-term staying power. The odds that a fund will wind down greatly increase when its asset base stagnates below $100 million. Assessing fund closure risk is important. Shuttering a fund may result in a taxable event for investors; it could be accompanied by associated costs, some of which may be borne by investors; and a liquidation will almost certainly lead to uncomfortable conversations with clients for the advisors that recommended the ETF.

The data show that investors already know this and are generally avoiding smaller funds. The 46 actively managed ETFs with less than $100 million in assets hold just 7% of total active-ETF assets. Most of these smaller funds will likely languish and many will ultimately die on the vine. Four have closed this year and more will follow. Actively managed ETFs with less than $100 million in assets have accounted for just 6.4% of net inflows into the category the past 12 months.

Low costs are one of the hallmarks of the ETF wrapper. Unfortunately, that would not be immediately apparent to someone examining the current lot of active ETFs.

One fourth of active ETFs have annual expense ratios in excess of 1% (albeit those funds account for just 5% of active ETF assets). Meanwhile, the asset-weighted expense ratio of the group of active ETFs with more than $100 million in assets is just 0.55%, largely due to the influence of the PIMCO Total Return ETF. This is further evidence that investors have already spotted many of the weeds in this field.

The More Liquid the Better
It is vital that fund companies never forget what the "ET" in ETF stands for. Working with market makers to foster liquidity in their funds' shares is a key aspect of creating a favorable investor experience. The failure to keep markets honest on the part of the fund sponsor could result in wide bid-ask spreads or persistent premiums or discounts versus the fund's net asset value. These dislocations could result in additional costs to the end investor, costs that don't enter the equation when dealing in traditional mutual funds.

I looked at the average liquidity levels for the current lineup of active ETFs, breaking the group into two along the size levels I mentioned above. There are clear differences. The median of the average daily trading volume amongst the active ETFs with more than $100 million in assets over the trailing three months was 92,959 shares per day. This is more than 14 times the comparable figure for the group with less than $100 million in assets. Scant liquidity is another reason why these funds will likely languish.

Pillars of Success
The pillars of the Morningstar Analyst Rating for funds are also pillars of success in the land of active ETFs. It is no coincidence the largest actively managed ETF, PIMCO Total Return, happens to be the sibling of the largest mutual fund on the planet. Gold-rated  PIMCO Total Return (PTTAX) has employed a rigorous process to handily best its benchmark since its inception in 1987 with Bill Gross, Morningstar's Fixed-Income Manager of the Decade for the 2000s, at the helm.

Similarly, the remaining four funds that make up the five largest actively managed ETFs also have experienced specialists working behind the scenes.  WisdomTree Emerging Markets Local Debt (ELD) and WisdomTree Asia Local Debt are subadvised by an experienced fixed-income team at Mellon Capital Management Corp. SPDR Blackstone/GSO Senior Loan ETF (SRLN) marks GSO/Blackstone's first foray into a vehicle offering daily liquidity in the bank loan sector. GSO/Blackstone is one of the world's largest loan buyers, occupying an important position in a somewhat esoteric and fairly illiquid asset class. And like its larger sibling PIMCO Total Return,  PIMCO Enhanced Short Maturity ETF (MINT) taps into the Newport Beach, Calif.-based firm's procedural rigor and deep bench of experienced analysts and portfolio managers.

So, while active ETFs may be the new kids on the block, the people behind the segment's success stories have proven processes and track records that testify to their merit.

The Not-So-Secret Recipe
There is no secret recipe for success in active ETFs, but there are some common ingredients in those funds that have flourished. While the numbers outlined above can help to narrow down the field, they don't tell the whole story. There are three common attributes that define the success stories in this space:

1.) The most successful active ETFs have generally been those sponsored by established firms.

2.) The managers at the helm are experienced and have proven track records.

3.) Most importantly, these funds have successfully leveraged the attributes of the ETF wrapper to reduce costs for investors.

For example, PIMCO Total Return can be purchased in an amount as small as a single share. (The shares were trading at $103 each in September.) The ETF version has no loads (though investors may pay brokerage commissions and will cover the bid-ask spread) and charges an annual expense ratio of 55 basis points. Meanwhile, the mutual fund version has a minimum investment requirement of $1,000, a front-end load of 3.75%, and an annual expense ratio of 0.85%. For investors, the math clearly favors for the ETF.

The potential to reduce the cost of investing is the single most promising feature of the active ETF category. To date, those firms that have realized and harnessed this potential have had success. Meanwhile, those that have used the wrapper more as the basis for a marketing strategy than an avenue to lower distribution costs have fallen flat.

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