By Ben Johnson, CFA
Capital Research and Management Company, the firm behind the storied American Funds franchise, has been on the ropes for years. The firm's cold streak began in 2008, and in the intervening six-plus years, the company has seen approximately one quarter of one trillion dollars of investors' money leave its lineup. That said, even after accounting for these outflows, American Funds remains the third-largest fund family in the U.S.
The reasons underlying American Funds' woes are many and were expertly documented by my colleague John Rekenthaler in a pair of articles: "Unlikely Cousins" and "The Wrong Side of History." He argues that investment performance has done little to take the shine off of this fund family:
American Funds is struggling because of distribution and marketing decisions, not because of performance. This is relevant because American Funds is often held up as an example of the failure of active fund management. But that is not so, and to interpret American Funds' business difficulties as a comment on the issue of active versus passive management is to misread the data.
I mostly agree. The family dodged a bullet as it sat out the tech bubble, and subsequently attracted large net new inflows. However, its relative performance during the 2008 market downdraft was less impressive, and when considered in the context of the points Rekenthaler makes, this rounds out the list of reasons explaining its recent struggles. However, recent efforts from Capital Group indicate that it is now moving to make up for lost time.
Don't Call It a Comeback
The firm's first counterpunch took the form of a national PR blitz launched last year to tout "the active advantage." Rekenthaler summarized the case Capital Group makes for active management in "The Empire Strikes Back." Based on Morningstar's Asset Flows data for the 12-month period ended June 30, 2014, it's apparent that this punch never landed, as the firm saw a collective $10.5 billion in net outflows. But Capital Group is still swinging. On July 25, it submitted a filing with the SEC for the "Capital Group ETF Trust." The filing details Capital Group's plans to launch nontransparent actively managed exchange-traded funds that leverage a structure developed by Precidian Investments. This is, in effect, equivalent to the purchase of a long-dated call option on ETF "technology."
What does this mean from Capital Group's point of view? First, it's a clear indication that the firm has finally acknowledged that investment-wrapper "technology" has advanced considerably since the ink dried on the 1940 Act, and that ETFs reflect the latest evolution in the way investment strategies are delivered to investors. Asset managers delivering their strategies in ETF form are akin to authors moving from fighting (and paying) for shelf space at local booksellers to being self-published so that anyone with an Internet connection can download their work instantaneously. This way around traditional distribution channels has been most notably exploited by Vanguard, whose ETF share class was an inroad to wire houses and other channels where their mutual funds never made it to the shelves. In many ways, Vanguard's ETF "straw" has allowed it to take quite a gulp out of American Funds' "milk shake" (see exhibit below), giving it an in with previously impenetrable channels such as the national wire houses.
Fund Family Net Flows
Source: Morningstar Asset Flows.
It's also notable that Capital Group has filed for nontransparent actively managed ETFs. The SEC currently requires actively managed ETFs to disclose their full portfolio holdings on a daily basis. This has made actively managed ETFs a nonstarter for many active managers who don't relish the idea of playing a game of poker with their cards facing out toward their table mates. Precidian's blind trust structure (which has yet to receive SEC approval) would allow portfolio managers to disclose their holdings with the same frequency as their traditional mutual fund counterparts--on a quarterly basis, with a lag. Clearly, an option that would allow Capital Group to keep its "secret sauce" under wraps is, from their perspective, far more palatable.
A new wrapper that simplifies distribution while preserving Capital Group's managers' best ideas may be the one-two punch the company needs to finally get off the ropes.
But what might this mean for investors? As I see it, there are three main prospective benefits for the average investor when it comes to buying a proven strategy in an ETF wrapper: 1) lower costs, 2) improved tax efficiency, and 3) greater accessibility. The potential for the ETF wrapper to reduce the cost of investing in Capital Group's funds is perhaps the most promising prospective benefit. To the extent that the operational costs of an ETF tend to be lower than those of running a traditional mutual fund, and assuming that all or some of these potential cost savings are shared with end investors in the form of lower fees, this could be a very positive development. As Jack Bogle has said, "In investing, you get what you don't pay for."
The structure also has the potential to improve tax efficiency through the use of in-kind redemptions--meaning that the fund can dispose of low-cost-basis securities in-kind, handing them over to an authorized participant as opposed to selling them and realizing distributable capital gains. This selling point is particularly compelling in the current market environment, as fund managers have drawn down the deferred losses they realized in and around 2008 and have begun distributing sizable capital gains.
Lastly, the flip side of broader distribution is greater accessibility. ETF shares can be traded in an amount as small as a single share and can be bought or sold by anyone with an online brokerage account. This type of direct distribution disintermediates any number of middle men occupying the space between asset managers and their end investors and can serve to further reduce the cost of investing. It would also mark a major change in American Fund's traditional distribution strategy, which has been centered around a loyal advisors.
Are a broader, lower-cost distribution mechanism for asset managers and a lower-cost, more tax-efficient, more accessible instrument for investors too good to be true? Well, it's still somewhat of a fiction. While there are a handful of very successful fully transparent actively managed ETFs (most notably PIMCO Total Return (NYSEARCA:BOND) and PIMCO Enhanced Short Maturity (NYSEARCA:MINT)) that would seem to be evidence that everyone can walk away happy, there are plenty of others that are helmed by unproven managers, fail to pass the low-cost litmus test, or both. More importantly, the SEC has yet to give the green light to any of the nontransparent active ETF structures that are currently in its inbox.
What's the holdup? The various filings for nontransparent active ETFs currently sit with the SEC's Division of Trading and Markets, which "establishes and maintains standards for fair, orderly, and efficient markets." This is a relatively tall task in the case of nontransparent active ETFs. Market makers are the linchpin of the ETF ecosystem. Their hard work keeps ETFs' market prices in line with their net asset values. In exchange for matching buyers and sellers, market makers pocket a spread, the difference between the highest price a buyer is willing to pay for an ETF (the bid price) and the lowest price at which a seller is willing to part with their shares (the ask price). Market makers hedge the risks that they take in the course of matching buyers and sellers, and to do so they need some idea of what exposures an ETF is assuming. In the case of nontransparent active ETFs, market makers would be faced with a lack of transparency and a smaller tool kit with which to hedge risk. Facing a greater level of risk, it is likely that market makers will require greater reward for making markets in nontransparent active ETFs. Large and potentially volatile trading spreads and discounts and premiums to net asset value are likely at the top of the SEC's list of concerns surrounding nontransparent active ETFs. In practice, there is the potential for large and volatile trading costs to dent the prospective cost savings outlined above that would otherwise accrue to investors.
It's not clear if or when the SEC will give nontransparent ETFs the all-clear. What is clear is that Capital Group and others are wagering on a potential secular change in investment wrapper technology--one that could potentially reduce costs for a broad swath of investors.
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