When comparisons are made between actively-managed ETFs and their competitors, they are often compared with their passive counterparts. The 4 pillars of the ETF structure that gives it such an advantage is their liquidity, tax efficiency, transparency and of course low cost. The argument is made that Active ETFs are deficient to Index ETFs because they are usually more costly, less tax efficient because of more trading costs, and less transparent because active managers are reluctant to disclose their holdings.
Those arguments may be accurate, but here’s where I feel there is a disconnect. Just because they are “housed” in the same ETF structure, doesn’t mean that Active ETFs are direct competitors of Index ETFs. Actively-managed ETFs compete with Index ETFs to the same extent that stocks in general compete with bonds for investor’s money. Investors who are looking to pursue an equity investment strategy will only be choosing between equity securities and not look at bonds and vice versa for those pursuing a fixed-income strategy. Yes, these two strategies compete in general for investors’ money but that makes them indirect competitors and not direct ones, like one stock versus another. Likewise, investors who are looking to purse an active management strategy believe that markets are inefficient and will look for actively-managed products instead of passive products. By implication, the main competitors that Active ETFs face are actively-managed mutual funds and not passively-managed Index ETFs because they are two entirely separate strategies.
As in the case of stocks versus bonds, yes, in general Active and Index ETFs compete for investors’ money. Hardly any investor’s portfolio is entirely active or entirely passive. When the mispricing of securities in the market declines, you’ll see money flow to passive strategies, and when you see mispricing rise, money will flow to active strategies. Both strategies have their place in the market, and we’re not going to see either one disappear anytime soon because it is the active strategies that reduce mispricing so that markets are efficient enough to justify the existence of passive strategies. Instead, competition lies WITHIN each of those investment strategies as investors look to find the best structures to express their active or passive views on the market.
With that in mind, it becomes clear why Active ETFs could experience some exponential growth from here on. Because when compared to their actual competitors, actively-managed mutual funds, Active ETFs are indeed more liquid, they are more tax efficient, they are more transparent and they are lower cost.
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Hi Shishir,
You bring up an interesting points. I like that you are comparing active ETFs against active mutual funds. Some financial advisors I speak with don't see that comparison as “apples to apples” because they aren't completely fee-based and they are compensated differently if they position a client in an active mutual fund, but I suspect that you are on to something that the compensation difference will be overcome by the ETF's advantages (which you state clearly) as an investment vehicle.
One thing I would like to bring out is that when I ask financial advisors about how they make recommendations between actively managed funds vs passively managed funds the financial advisors usually point first towards “alpha” not towards cost efficiency. Once “alpha” is the reason, then isn't it appropriate that the active manager performance should be benchmarked against an appropriate index? How else would a claim of “alpha” be substantiated? From that point of comparison, if an index-based ETF exists which tracks the index benchmark, then if the active manager can't prove alpha (or risk-adjusted alpha) and they are charging more bps to manage, then its hard to see how the financial advisor or his/her clients are not better off in the index-based ETF.
Regards, Shaun
Hi Shaun,
From an advisor's point of view, there is of course a difference because they don't get paid in the same fashion by selling investors ETFs as they do for mutual funds. But these days, the power is in the hands of the consumers, in this case — investors. I like to call it the democratization of the investment space. If investors want it, sooner or later, advisors will have little choice but to start offering it to them.
And to your second point, I agree totally. Active ETFs will NOT draw any money in the long-term if they're not able to perform better than their benchmarks, that is for sure. They do have a better shot at it though. Active mutual fund managers have traditionally been hampered by a high expense fee that reduces the net returns of the fund which is used to measure performance. But with that fee hurdle greatly reduced through the ETF structure, managers get a head start (or should I say they get less of a handicap) and should be able to outperform relatively more easily.
Thanks for your comment.
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