What Trade-Offs Do Active ETFs Face?

Primecap’s New ETF

Primecap recently launched a new ETF, Primecap Odyssey Discovery ETF POMG, on Oct. 20. Hundreds of discretionary active exchange-traded funds are currently on the market, but this one is a little more interesting for a couple of reasons.

First, Primecap doesn’t manage many funds. It only manages six in the US: three under its own branding and another three that it subadvises for Vanguard. The newest of the six was created in late 2004.

The other, and perhaps more important, point is that a lot of investors couldn’t access them. Primecap has been very sensitive to the amount of money that it manages. It has not hesitated to limit new money coming into its mutual funds, if not completely shut down access, as they grew larger.

There’s good reason for that: Funds that consistently perform well tend to attract investors. New money and high rates of return cause funds to get bigger, and that success creates a problem: The managers have fewer places to invest each marginal dollar while retaining their edge. Saying “no” to new money is one way to limit that growth and maintain their potential to outperform.

As an asset manager, you can do that with mutual funds. It’s one of the reasons why mutual funds work well for active managers and their investors. The practice can protect current shareholders by retaining a fund’s potential to outperform, but it slows down a fund’s growth and costs the asset manager some additional revenue.

However, exchange-traded funds don’t have that provision. They can’t really shut their doors to new money because they actively trade on an exchange. In theory, you could halt the creation of new shares, but that would likely cause the ETF to trade at a premium to its net asset value. As a manager, you may have solved the capacity problem, but you’ve created another issue.

The Primecap ETF has another quirk. Similar to one of its mutual funds, Primecap Odyssey Aggressive Growth POAGX, it sits in the mid-cap growth

. Right now, its holdings skew toward smaller stocks, and funds built around smaller stocks are typically more capacity constrained than large-cap funds. In other words, they can’t manage as much money as large-cap funds and still maintain their edge.

On the surface, it’s a different look for Primecap.

The Active ETF Paradox

Primecap’s new ETF highlights a trade-off that active managers face when migrating to ETFs from mutual funds. Broadly speaking, they can choose one of two routes:

1. Invest in large-cap stocks. There’s plenty of capacity because the market value of large caps is quite big. However, the competition is stiff, and the long-term success rates are low. Managers probably avoid capacity concerns, but outperforming will be difficult.
2. Invest in small-caps. The long-term success rates are meaningfully higher, and managers stand a better chance of outperforming. The problem they’ll face, eventually, is that they can’t manage as much money and maintain that edge compared with a large-cap fund. Small-caps are a smaller market, and large trades can push prices around and eat into a fund’s total return. Managers may find outperforming a little easier, but they can’t effectively manage as much money.

It’s a bit of a simplification, but it illustrates the trade-off. An active ETF could increase the amount of money it’s capable of managing by broadening out the number of stocks it holds, but then it looks more like an index fund and potentially gives up some outperformance. The trade-off hasn’t changed.

Primecap appears to have chosen the second path for its ETF, but most active discretionary managers have opted for the first. About two-thirds of all active discretionary stock ETFs landed in one of the three large-cap segments of the

at the end of October. Only 95 of the 825, less than 12%, landed in one of the three small-cap segments.

Discretionary Active ETFs By Size and Style