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Are Actively Managed ETFs Finally Ready For Prime Time?

A story in the May 13, 2013 edition of Barron’s noted that “…many industry observers are convinced that 2013 is the year active ETFs will hit the big time.” On that date, the universe was small: just 1% of the assets in ETFs were invested in active strategies. Over 7 years hence, the active share has reached a whopping 3%.  The slow progress serves as a reminder that humility is the most important quality in forecasting. But recent changes to the regulatory structure and the growing popularity of the ETF as a vehicle have created an environment more conducive to active strategies. Perhaps 2020 is the year.

Exchange Traded Funds have become widely adopted by investors over the past 20 years as an alternative to traditional mutual funds. Similar in concept, both vehicles allow investors to access to a proportional ownership in a larger portfolio of stocks, bonds or commodities without owning individual securities. But the actual structures of the two vehicles differ significantly. While mutual funds are priced and purchased and the end of each trading day, ETFs trade actively throughout the day on the major exchanges like individual stocks. ETFs can also be more tax-friendly for investors in non-retirement accounts. But until now, they were limited to a somewhat narrower array of investment objectives.

The traditional mutual fund industry abounds with so-called “actively managed” funds: portfolios that employ specific strategies and actively purchase and sell securities according to the style and strategy employed by the manager. ETFs, by contrast, have tended to concentrate primarily in the passive index world, offering a plethora of funds that essentially mimic one of the thousands of market indexes like the S&P 500 or the Russell 2000. The passive index strategy has proven widely popular in recent years, making up the lion’s share of the $5 trillion industry. But the times they are a-changin’.

Thanks to a 2019 revision in the regulatory landscape from the SEC, ETFs may finally invade the active space more energetically. Under prior rules, all ETFs must disclose their individual holdings every day. For index funds, this is no problem. But active managers generally do not want their position details known in real time for fear of losing their competitive advantage (or at least perceived advantage, a column for another day). Mutual funds are required to show their cards only once a quarter.

The SEC approved 5 different new ETF structures allowing for less frequent or fulsome disclosure of fund holdings. The most opaque of the new structures allows for quarterly reporting, essentially like current mutual fund regulations. Other variants include daily disclosure of individual holdings but not their specific allocations in the fund portfolio.

Many fund companies are now bringing clones or close copies of their mutual funds to the ETF market, including giants American Century, T. Rowe Price and Fidelity Investments. So far this year, 15 new offerings, dubbed semitransparent ETFs, have come to market under the new rules.

One major hurdle still restrains actively managed ETFs from hitting their stride. Retirement plans like 401(k)s rely heavily on mutual funds because participants can purchase fractional shares in traditional open-end funds. ETFs must typically be purchased in whole shares. But this too is changing with many brokers now offering fractions of a share in individual stocks, and some providing limited ETF availability in smaller bites. No doubt this becomes a non-issue in due course and opens the door for wider adoption in retirement plans.

Most analysts expect growth in ETF popularity to continue throughout the next decade, with the active versions gaining more market share. With all humility.

Christopher A. Hopkins, CFA

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