Journal of Financial Planning: December 2013
Rick Ferri is author of The ETF Book. He continually monitors and evaluates the latest trends related to index funds and ETFs. His research appears frequently in many major media outlets, including The Wall Street Journal, Financial Times, New York Times, and Barron’s.
The exchange-traded fund industry is hot for actively managed ETFs. Many insiders see this as the next big thing. Dozens of fund companies have filed with the SEC for new products. They have their noisemakers out and are ready to party. All that’s needed are investors—and therein lies the problem; there are few to be found.
In recent years, investors have moved several hundred billion dollars from actively managed funds into low-cost index funds and ETFs. Repackaging active management in an ETF wrapper isn’t going to reverse this trend. The overall cost for active management is likely to be lower under an ETF structure, but cost isn’t the problem—the problem is performance.
ETF Adoption Boosts Indexing
Active managers have been underperforming their benchmarks for decades. This fact has been widely documented in academia and in industry studies. It’s the reason John Bogle offered index funds through Vanguard starting in 1976, and it’s the reason Fidelity, Schwab, State Street Global Advisors (SSgA), Barclays, etc., have followed in his footsteps.
The recent adoption of ETFs by the adviser community has added fuel to the fire. Even brokerage firms now embrace the idea of index-tracking ETFs as the core of a well-diversified portfolio. This was unheard of 10 years ago. The prospect of a uniform fiduciary standard for all advisers, including brokers, makes a core index-fund strategy even more appealing.
Ironically, Bogle isn’t an advocate for ETFs, because to him, the high turnover rates are a sign of speculation. That may be true; however, the boost that indexing in general has received because of ETF adoption by advisers has to be appreciated.
Where assets go, active management follows, and indexing is no exception. It started in 2003 when PowerShares launched two ETFs that followed Intellidex indexes. These sophisticated quantitative strategies form rules-based “strategy indexes” that are meant to outperform the markets. The term “fundamental indexing” was coined by Research Affiliates shortly thereafter. That strategy weighs stocks and bonds by non-cap weighted factors.
Strategy indexes have been mildly successful over the years. This has been helped by some creative marketing by ETF sponsors and index providers. They cunningly label their active methods as “intelligent indexing” and “smart beta.” These strategies are capturing about one-third of all new equity ETF flows, according to industry sources.
Full active management inside an ETF is relatively new. As the name implies, these funds do not track indexes. Portfolio managers select securities that they believe will beat their benchmarks. PowerShares was first to launch actively managed ETFs in 2008. Their two funds have since closed due to a lack of investor interest.
Most actively managed ETF funds launched since 2008 have struggled to attract assets, but there are exceptions. PIMCO scored big with a couple of fixed-income funds. The PIMCO Total Return Exchange-Traded Fund (BOND) has attracted $4 billion in assets. The expense ratio (ER) for BOND is 0.55 percent. That’s cheaper than the $251 billion open-end version of the fund (PTTAX), which sports an ER of 0.85 percent for Class A shares along with a 3.75 percent maximum sales charge.
BOND and PTTAX are both managed using similar strategies by legendary bond investor Bill Gross. This makes me wonder if the $4 billion that went into BOND was money that would have gone into PTTAX. The advocates for actively managed ETFs say there was no cannibalization. I’m not so sure.
Like traditional actively managed funds, the success or failure of an actively managed ETF will rely on one factor: performance. Putting active management under a lower-cost ETF umbrella isn’t a panacea for bad management. Unless active managers get better at their craft, the party for actively managed ETFs may be over before it starts.