In a report published by State Street Global Advisors (SSgA) called “Vision Focus”, SSgA discusses actively-managed ETFs and the resulting changes that they have brought to the ETF landscape and how ETFs are serviced.
The report focused on several important points about Active ETFs and one of them was that “actively and passively managed ETFs should be able to co-exist because they fill different needs in investors’ portfolios”. This is a point that has been discussed quite frequently at ActiveETFs | InFocus, and the key is to see that active and passive ETFs are intended for two completely different purposes and should not be seen as substitutes. An investor who has decided to pursue a passive management strategy for their portfolio, will only consider investment instruments that offer him/her index returns – they will not consider actively-managed ETFs appropriate for their portfolios. But there is also a large chunk of investors who want active management of their portfolios, which is the investor group that actively-managed ETFs target. In reality, as SSgA’s report points out, most portfolios are likely to have an actively-managed portion and a passively-managed portion, and there’s a place for both index and active ETFs in portfolios. The difference from before is that with the arrival of actively-managed ETFs, investors can fulfill both their active and passive needs with ETFs alone, which have been shown by many to be a superior investment structure to mutual funds.
Another point the report makes is that ETFs have historically had very low expenses and that has been their big selling point. But with actively-managed ETFs, it will most likely not be possible anymore to keep expenses at rock-bottom levels because of the increased management expertise required in running the fund. “So how can the low expense ratios be maintained despite the additional costs?” In my opinion, that is the wrong question to ask because it implies a direct comparison in costs of Active ETFs and other traditional passive ETFs. A cost comparison between index and active ETFs is not a fair comparison to make precisely because of the points made in the previous paragraph – the two products offer investors a completely different value proposition. Judging these products based on a cost comparison is like comparing the price of a cell phone to an iPod and concluding the cell phone is inferior because it’s more expensive. First, the cell phone is meant for an entirely different purpose than an iPod so a comparison in costs is unfair because you’re not “valuing” the same thing. Second, the amount of “workmanship” that goes into a cell phone is likely more than what goes into an iPod, hence justifying the higher price. The same logic applies when we are thinking about index ETFs and actively-managed ETFs. Where a cost comparison would be relevant and appropriate would be between Active ETFs and active mutual funds, because they do indeed provide the same value proposition to the investor.
State Street also raises the all important issue of disclosure for actively-managed ETFs. It points out that ETFs by definition (at least in the US) have to provide complete transparency of holdings. But in the case of Active ETFs, that transparency also means the portfolio managers have to “show their hand” at the end of every trading day, leaving them vulnerable to front-running and duplication of their strategy. This issue has quite definitely been a curve ball for the ETF providers and fund managers and no resolution seems to be in sight yet. In fact, BlackRock iShares has been seeking approval from the SEC to launch actively-managed ETFs with less disclosure in order to circumvent this problem. But in my opinion, it is very unlikely that the SEC will take a step that helps out the product manufacturers at the expense of the investors, especially given that there are already Active ETFs out there which are apparently competing successfully even with full transparency.
State Street’s Vision Focus reports and other reports in the “Vision Series” can be found here.
Disclosure: No positions in above-mentioned names.
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