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The Active ETF: What's in It for Investors?

Adam McCullough, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Active exchange-traded products have hit the market in recent years, but most haven't yet gained much in assets. Joining me to discuss this phenomenon is Adam McCullough. He is a manager research analyst for passive strategies for Morningstar.

Adam, thank you so much for being here.

Adam McCullough: Happy to be here.

Benz: So, you recently wrote a piece for ETFInvestor about this phenomenon of actively managed exchange-traded products. Let's start by talking about what the value proposition would be for individual investors. What's in it for investors? What are the potential benefits of active exchange-traded products?

McCullough: Absolutely. So, it kind of comes down to two issues. One is cost, one is access. Access is easy. So, right now, the investor share class of a mutual fund might have a minimum investment that I have to be in to be …

Benz: $5,000, $10,000--whatever it might be.

McCullough: ... $5,000, $10,000. Whereas if I could offer that strategy via an ETF or a fund that's traded on an exchange, I could just buy one share at a time. So, I could access that fund via any brokerage account, and buy one share. So, for example, right now the SPY, the S&P 500 tracking ETF, is $230. So, I could buy that, be invested in the product, and not have to meet the minimum investment of the mutual fund.

The second is the cost. And so, this is also a bigger issue as to how ETFs trade versus how mutual funds trade. And so, if I'm a long-term investor in a fund, I put my money in and there's other fundholders who are coming and going throughout the 10, 15 years that I'm invested. I'm essentially paying for those transaction costs as the portfolio managers of that strategy have to buy and sell securities to meet shareholder redemptions, to put money to work, to do other things with the money. And so, basically with an ETF and the mechanism of the share creation and redemption process, I can avoid all of that, have my own tax slot, where I still pay a capital gain if I sell that share at the end of five, 10, 15 years, but I benefit from the fact that I have my own pool, essentially, of assets that I'm paying taxes on.

The other big thing is the mechanism for which how ETFs create and redeem shares. So, the market-makers for ETFs are authorized participants, usually bigger banks, there's probably eight or 10 of them in the U.S. And so, if they see that a fund is not trading close to the NAV of it, so the net asset value, they will either take shares out of the market, trade them to the ETF provider, or take shares of the ETF from the ETF provider and give them the underlying basket of stocks that represent that ETF and put it out in the market. And so, by doing this, it's not a cash-based transaction. So, there is no taxable event of selling, say, certain stock that have been in the portfolio for a long time and then that tax saving is passed on to the ETF holder.

Benz: That's what's in it for investors potentially.

McCullough: Correct.

Benz: In terms of the fund companies that might offer these exchange-traded products, the cynic in me says that they want to capitalize on the explosion in ETFs while at the same time maybe preserving a little bit higher management fees than they would be able to do with passive strategies. But beyond that is there anything in it for ETF providers in terms of offering actively managed products?

McCullough: Well, it kind of goes back to the same benefits from the investor's side. One, they can offer these strategies to investors with a lower hurdle rates--they're not having to meet an investment minimum, it's just one share on a broker account. The second one is that they are really able to compete with other ETF products that have this inherent tax and cost advantage. So you kind of have a more level playing field from that perspective. And part of the cynic in you is probably right, and it is an easy way to add distribution to a strategy without having to do a whole lot of extra work. I mean, the strategy is in place, the team is in place. Now, they can say, OK, let's plug into this exchange and then offer it to any investor that has a brokerage account.

Benz: Right. Now, in terms of asset inflows, in your article you noted that there have been some active ETFs that have launched and have immediately or shortly thereafter have gone belly-up or have liquidated. Let's talk about asset flows into these products. Most of them have been into some of the bond products, correct?

McCullough: Right. So, it's almost been a failure to launch, not really a launch of active ETFs. So, the first ETF was launched in 1993 by State Street, SPY, which tracks the S&P 500. The first active ETF was launched in 2008, in the spring of 2008, by Bear Stearns, very bad timing. And so, basically that was kind of the ready, set, stumble moment of active ETFs.

Since then the ETF market AUM in the U.S. has grown to about $2.5 trillion or $2.6 trillion while the active side has only gone up to $29 billion or $30 billion. So, it's 1% of the total ETF market. Part of the problem is that, one, for an ETF to trade on the exchange you have to give your portfolios daily so that the authorized participants can price those and know when to--hey, OK, we should create shares, redeem shares to get this trading in line with where it should be. So, that's the big issue with having more fixed-income-type of products out there compared to equity.

I think now in the total active ETF market that the top 10 funds represent more than two thirds of the assets out there and 75% of all assets are in fixed funds, 10% in equity funds, the remainder in currency and commodity funds. But right now, the top five are going to be PIMCO's, there's two funds up there I think in the top 5; SPDR did a partnership with DoubleLine, they also are in the top five I believe; and nine out of the top 10 actively managed ETFs are fixed-income ETFs. And the one equity ETF you have in there is not really an equity ETF; it's a MLP ETF, so a master limited partnership ETF, which essentially tracks an index but is categorized as an ETF. So, you've really seen a lot of movement in this space on the fixed side, not really on the equity side yet.

Benz: So, the reason for fixed income being so dominant here is just that are the portfolios so opaque or so ephemeral? What is the motivation for investors gravitating to the fixed-income managed products?

McCullough: Yeah, it really comes down to the fact that there is the SEC requirement to disclose the portfolio daily. And so, on the fixed side, there's companies that issue bonds of a multitude of durations, of coupons, of seniority in the capital structure, where on the stock side there's usually only one share class of stocks, sometimes there's two, but it's much easier to see which issue is out there.

And the second part of that is that you can copy the equity side much more easily. I can go out and see that Warren Buffett bought a share of Apple last time he had to disclose what he was buying and so, I think he is smart guy; I'm going to go out and do that. I'd be hard pressed to be able to go out and find one bond of any of the bonds that he was buying, because it's mostly traded over-the-counter, not on an exchange, and they are not traded in one-bond lots really.

And so, part of the hurdle for fundamental equity managers in offering their products through an actively managed ETF is getting past the fact that you're showing your cards every day. So, you can see this manager is building a position or exiting a position and they fear that someone else will jump in front of them to buy as much as they can before or sell which will move the price or down against them.

Benz: So, in your article you went into depth on some of the products that have attempted to solve for this transparency problem so people can read about that. But I want to just close by asking you about whether you think these products will ever gain any traction. It seems like they solve for some of the structural problems of active mutual funds, but maybe investors' problem isn't really with the structure but rather the performance and costs of a lot of active funds.

McCullough: Right. So, I think, what a whole lot of firms are trying to do is to get past the daily transparency but still benefit from the ETF structure. And actually, in mid-January, a fundamental fund company, Davis Funds, launched three active ETFs using their equity strategies. And so, basically what they did was, say, you know what, we're long-term investors, we build positions slowly, so we're fine with having our portfolios transmitted daily to the world. And so, I think that's an interesting case to see if they do take off, because they've had a long track record of fundamental equity management. And so, if these can gain shares and you can see that there's an investor preference for this vehicle over the mutual fund vehicle.

Like you said, I mean, it's kind of an, "if they build it, will they come?"-type thing to the active managers. There has been a well-documented flow to passive strategies. Will that reverse? I think time will tell. But if you can implement a more active strategy that is inherently less tax-efficient because you're trading more and churning over more, in a more tax-efficient structure, it might be beneficial to the end investor.

Benz: OK. Adam, interesting research. Thank you so much for being here to discuss it with us.

McCullough: Thank you.

Benz: Thanks for watching. I'm Christine Benz for