Three reasons why the rising popularity of Active ETFs will benefit the investor

Allan Lane, Algo-Chain

One of the surprising aspects of 2020 has been the speed at which the concept of ‘active management’ in the pursuit of alpha has been rehabilitated, and in the long run I suspect this will benefit the ETF industry. 

It hasn’t been that long since Neil Woodford, one of the UK’s most famous stock pickers, fell from grace, when he had to close his fund due to poor performance. Based on my own anecdotal evidence, it’s quite clear that many investors and their financial advisers still believe in the benefits of stock picking. Who can blame them, surely it must be true that if you pay more to access the expertise of a seasoned investment manager then the outcome will be better?

If it was only that simple. In the same way that it is often investor sentiment that drives stock market returns rather than the hard-cold facts in front of them, so it is with selecting funds. What you believe in appears to matter more than what might be backed up by the hard evidence.

With the news that both Fidelity and JP Morgan recently threw their hat into the active ETF ring, then it would be fair to say it will only be a matter of time before hundreds of others will follow suit. After years of debating how many active angels one can fit onto a passive pinhead, the time has come to move on from that sterile debate. As the acceptance of the idea of active ETFs takes hold, we may well look back on this era as the time when the fund management industry finally went ahead with its own ‘5G’ revolution. Here are three reasons why the end investor will surely benefit.

A much healthier industry

As active ETFs come to the fore, expect some of the pressure on fees to subside as these funds will be launched with higher management fees. If you recently blinked you may have missed the announcement that the US ETF issuer, SALT, famous for their negative fees, is no more. In the race to zero on management fees, the end investor finds themselves constantly having to worry about the staying power of the parent fund manager, companies cannot live on thin air alone. This creates a winner takes all culture which is less than ideal if you want to build a healthy industry, and before you know it the monopoly power of the biggest firms comes into play. If the Wealth Management industry is to truly provide a service, it cannot operate in a world where the margins are cut to the bone. 

The words active and passive will be confined to history

Tracking the FTSE 100 means the portfolio needs to be re-balanced every 13 weeks. Passive funds have never been passive; however, the re-balancing rules are often so simple no one gives it any thought. By contrast I suspect a lot of ETFs that were once classed as Smart Beta will in the future be re-labelled as active funds. 
 
The bottom line is that all fund management is an active process, and consequently the only three questions to ask are: what is the process by which stocks are selected, is that process transparent, and how high is the turnover? In a world were both passive and active ETFs co-exist, these labels will become less important as and the investor will be able to much more easily compare outcomes. If you are looking to launch an active ETF, be careful what you wish for. Eventually the spotlight will fall on the issue of transparency and it seems unlikely that underperforming non-transparent active funds will survive the cut. 

Skill will become the commodity that matters

Exactly how does a fund manager select bonds for inclusion in an active ETF? If you have ever looked at the holding of many Fixed Income ETFs then you will realise what a painful task that is. One day you are sitting on a portfolio of 3-year Treasuries, then hey presto, you look three months later, and the duration of the portfolio has dropped by 0.25 years. In most instances it is not possible for a human to scan all of the eligible bonds, that can only be done by using technology to do the heavy lifting for you.

It turns out many of those active ETFs are not using the expertise of a ‘Bond or Stock Picker’ after all but will instead be relying on an intricate filtering process overseen by a computer. Differentiating between a manger’s skill and a piece of intelligent software, will in the end matter, and investors will no longer have to pay higher fees to index huggers. As with any sales opportunity, managers that have the superior product (as in being able to demonstrate real skill) and equally as important is the ability to run a good marketing campaign, will be the winners. 

In truth we do not live in a world where investors only ever invest in a single fund, which goes to explain why model portfolios have become the worst kept secret of the wealth management industry. With an estimated USD4 trillion of assets packaged as Model Portfolios in the US and UK combined, we should all look forward to the day where more investors realise, it’s what’s in the combined portfolio that counts.

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