Two Opportunities for Active ETFs to Record Massive Growth

Feb. 5.10 | About: PIMCO Short (SMMU)

As many well-known issuers like PIMCO, Vanguard, Claymore and many others line up to bring their actively-managed ETFs to market, it appears that these relatively new products are poised for a strong growth phase. With major regulatory hurdles out of the way, and with the SEC having already approved about 15 active ETFs that have started trading, subsequent filings and approvals should take much less than the 2-3 years it took the pioneer, PowerShares, to bring their products to market.

Having passed the initial hurdles, active ETFs are at a crossroads where their growth could explode from here, or become tepid and non-existent. Much of that depends on how new issuers grasp two huge opportunities that Active ETFs are presented with today.

1. Penetrating the $12 trillion mutual fund market

The US mutual fund industry currently manages in excess of $12 trillion in assets, with global mutual funds managing more than $26 trillion. In comparison, Active ETFs in the US currently manage about $200 million. Now, more than 95% of mutual funds are in fact actively-managed. At the same time, many studies have shown that active mutual funds have failed to beat the market benchmark they follow, over an extended period of time, after deduction of fees. This is where the big distinction between actively-managed ETFs and active mutual funds comes in.

The average expense ratio for an active mutual fund, according to Lipper, is 1.21%. In contrast, the average expense ratio for existing actively-managed ETFs is 0.70%. By those numbers, that provides for an immediate cost benefit (and hence return benefit) of 0.51%. To look at a direct example, even in the fixed-income markets where mutual funds usually have lower expenses, active ETFs do better – PIMCO’s recently launched Short Term Municipal Bond Fund (NYSEARCA:SMMU) sports an expense ratio of 0.35%, in comparison to the equivalent mutual fund, PIMCO’s Short Duration Municipal Income Fund A (individual class) which has an expense ratio of 0.73% even though the two funds are managed by the same portfolio manager, to near identical strategies.

Hence, with lower fees, active managers will have a greater chance of outperforming the market. A study conducted by the Financial Research Corporation (FRC) indicated that people invest in ETFs mainly because of their cost advantages. These cost advantages were so far enjoyed by the passive management field, which explains why index ETFs have a much larger share of the passively-managed market than do index mutual funds. Now, active ETFs have brought the same advantages to investors looking for active management and with a large majority of mutual funds being active, the potential for market share gains is huge.

2. Penetrating and becoming a core part of 401k retirement plans

The other benefit of active ETFs, and ETFs in general, is their transparency and tax efficiency. With daily disclosure of holdings, investors can know exactly what’s going in and coming out of their portfolios and that also helps reduce any deviations of the market price from the fund’s net asset value. This is what makes these new products attractive to financial advisors, who are most often the gatekeepers to investors’ 401k plans in the US or RRSPs in Canada. The Financial Research Corporation also took a poll of advisors, 48% of whom believed that active ETFs will gain traction and replace active mutual funds.

The 401k plan users have as a whole shown a preference for active management while also wanting to reduce the costs on their investments – active ETFs provide this combination of benefits. However, over the past 20 years, mutual funds have become entrenched in retirement portfolios and they will be difficult to displace despite the obvious advantages of active ETFs. But if investors start to see the benefits, then the displacement of mutual funds could be very swift.

With ETFs already dominating the passive management arena, the time may be ripe for similar market domination in the active management space.

Disclosure: No positions