Active managers have been locked in a 30-year war of attrition against passively managed exchange-traded funds, which have transformed from niche to juggernaut, representing roughly $4 trillion in assets today.
However, a recent decision by the Securities and Exchange Commission, which paves the way for active managers to offer so-called “nontransparent” ETFs, is being vetted by a number of industry participants as potential salvation for beleaguered money managers, who have both underperformed passive ETFs that track an index, like the S&P 500 SPX, +0.54% SPY, +0.57% or the Dow Jones Industrial Average DJIA, +0.91% DIA, +0.91% and experienced eroding market share.
On Monday, the SEC issued a decision, allowing Precidian, which owns the ActiveShares ETFs, to begin working with mutual-fund providers, including Legg Mason, American Century Investments, BlackRock Inc. BLK, +1.64% Capital Group, and JPMorgan Chase & Co. JPM, +4.12% among others, to create actively managed ETFs.
Unlike currently available ETFs, nontransparent ETFs wouldn’t have to disclose the fund’s holdings at the end of the day and proponents argue this provides sponsors greater cover to execute proprietary trading strategies and avoid prying investors and rivals who might want to front-run certain investment ideas.
Chiefly, however, advocates of nontransparent ETFs said the SEC’s approval of the product provides active managers with a fresh tool for attracting and retaining investors, because it would enable them to offer the tax benefits inherent to ETFs due to their structure.
“Active managers have sat on the sidelines as ETFs have taken greater market share through a tax-advantaged structure and ease of trading,” Stuart Thomas, principal at Precidian told MarketWatch. “We’re giving the active management community another option for offering their products.”
ETFs typically have to pay less capital-gains taxes than mutual funds, because of differences in the how they are engineered.
For example, when a shareholder of a mutual fund wants to sell his or her shares, the mutual-fund manager must raise dollars by selling securities, which, in turn, may create a taxable event. Those taxes are borne by the shareholders in the fund.
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On the other hand, when ETF investors want to unload shares they simply sell them to another buyer on an exchange. The seller of the ETF may be required to pay capital-gains taxes if the shares she personally owned appreciated in value, but the fund itself avoids doing so by not trading to raise cash for a redemption.
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“We’ve seen in recent years that even high-quality managed mutual funds have been paying and additional 5% to 10% of their assets under management in tax,” Grant Engelbart, director of research and senior portfolio manager at the registered investment adviser CLS Investments, told MarketWatch.
Engelbart said the nontransparent ETF structure for an active manager would provide a meaningful ability to reduce taxes that would occur in a mutual-fund structure and thereby increase the overall return for investors. “The tax component is a huge layer of additional cost.”
Moreover, ETFs are also more stocklike and therefore more liquid and tradable than their mutual-fund counterparts. Mutual-fund investors can seek to redeem their investments at any point, but won’t receive their money until the end of the trading session when those funds settle at the exchanges at which they predominantly trade.
Although, ETFs aren’t intended to be a trading tool (they are viewed as long-term investments), the convenience of being able to quickly buy or sell ETF shares intraday is a big deal on Wall Street, particularly during whipsawing periods in the market, experts said.
“We believe in the not too distant future that we will look back on the introduction of nontransparent ETFs as a key catalyst for growth in active managed funds,” Rick Genoni, head of ETF product at management at Legg Mason told MarketWatch.
Legg Mason owns a minority stake in Precidian and is currently working with the company to develop a nontransparent ETF, which Genoni estimates could be approved by the SEC and available to investors sometime this summer.
It isn’t clear, however, how popular these nontransparent vehicles will be with investors, who have largely been fleeing mutual funds, in favor of the index-pegged ETFs, which also tend to charge a significantly smaller fees than passive exchange-traded funds. The average annual fee charged by mutual-fund managers in 2017 was 0.72%, versus 0.15% for passive funds, according to Morningstar’s latest fund fee study (registration required for complete report).
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In 2018, investors pulled $178 billion out of U.S. actively managed funds while adding more than $200 billion in passive funds, according to Morningstar data. These flows were likely driven by performance, as Morningstar estimates that roughly 65% of large-capitalization active funds underperformed the S&P 500 last year. So far this year, actively managed funds have seen inflows of $17.9 billion, though those flows are dwarfed by their passively managed rivals, which have seen inflows of $118.2 billion, year-to-date.
“It’s not the end investor that’s been clamoring for this product,” David Perlman, head of ETF research at UBS told MarketWatch, adding that the annual fund flows from actively managed funds to passively managed ones in recent years show waning investor interest in active management, no matter how it is packaged to potential buyers. “Lowering the cost and making it more tax efficient will help, but ultimately the performance has to be there,” he said.
That said, there is some evidence that interest in actively run ETFs could be stronger-than the lackluster appetite that some are predicting. That is because active management is making a modest comeback: In 2018, actively managed ETFs in the U.S. grew their assets under management by 66.4% versus 11.5% for passively managed ones, according to ETF research and consulting firm, ETFGI.
And while overall money invested in active ETFs is dwarfed by the amount swirling in passive funds, Legg Mason’s Genoni noted that actively managed mutual funds remain bigger than the passive ETF industry, pointing to that development as evidence of continued demand for active management.
“I appreciate the point that early on, ETF growth was all about passive management,” Genoni said. “but we see active ETFs as the next stage in the evolution of the business.”
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