Active ETFs: Allowing for Product Differentiation

 |  Includes: JPM, LM, TROW
by: Shishir Nigam

Actively-managed ETFs have continued to get attention from both the investing public and the manufacturers of the products that investors put their money in. The buzz generated about the active ETF space since 2008 has no doubt been increasing because of the large number of major financial players that have filed applications with the SEC to receive approval to launch these products. These include the likes of Legg Mason (NYSE:LM), PIMCO, JP Morgan (NYSE:JPM), Vanguard, T. Rowe Price (NASDAQ:TROW) and Eaton Vance – which just acquired assets of Managed ETFs LLC, a firm that owns patents which could provide the necessary trading framework for non-transparent actively-managed ETFs to exist.

The large amount of interest shown from various firms has naturally lead to the question of what the firms are trying to achieve by entering this new and nascent space in the ETF market. What’s their motivation? Scott Burns, Director of ETF Research at Morningstar, speaking to, probably hit the nail on its head. “When you open up with an active strategy in an asset class, they don’t become a ‘me too’ product. The active manager changes the timbre of the fund. That’s why you can have 8,000 active mutual funds," said Burns.

That highlights one of the main reasons why we are seeing so much interest in active ETFs from issuers. The U.S. ETF market, at last count by the National Stock Exchange, had 1,092 exchange-traded products, including ETFs and ETNs, with assets close to $950 million. Globally, the ETF industry well exceeds $1 trillion in assets now. Nearly every nook and creek of the investable spectrum has been covered off by ETFs, sometimes many times over, with several duplicate products competing on price. In other words, the passive ETF world has become highly commoditized. Anything that one passive ETF provider can offer is easily duplicated by another provider because there are hardly any barriers to entry or differentiating factors. Innovations such as fundamental indexing, inverse and leveraged ETFs have commanded some sort of a premium in the early stages of their introduction to the market, but they too are now commoditized, with competition coming down to price.

In that context, the active ETF space has provided issuers with some breathing room. There are currently only 32 actively-managed ETFs in the U.S. with a total capitalization of about $2.9 billion. Needless to say there’s lots of room to grow and niches to occupy. Most importantly, the prospect of active management actually allows issuers to erect some barriers to entry around successful products – barriers which can be held up by strong outperformance by their managers. In passive ETFs, the value-add of the manager – tracking the index closely – is easily duplicated. However, value-add for actively-managed ETFs comes from the skill and ability of the portfolio manager, something that is not as easily copied. Of course, this whole discussion is predicated on the assumption that there are some managers behind active ETFs who can actually outperform. That is an assumption yet to be tested fairly because of the relatively short history of these products. The first actively-managed ETFs will achieve their three-year track records only in April 2011.

Another post on SmartMoney addressed the same question in a different way. Jonnelle Marte argues that the motivation behind the interest show in active ETFs is a desperate attempt from active managers to retain some portion of their higher fees, which they have been losing due to the wide-scale move to passive indexing. That is quite definitely true to some extent. However, one point is lost in that argument. Many of the major firms clamoring to get into the active ETF space are in fact leaders in passive investment products. Just to name a few – iShares, Vanguard, State Street and PowerShares. These companies, not coincidently, are the top four providers of passive ETFs, combining to hold some 89% of all assets in the ETF space. So from their point of view, these companies are trying to extend the benefits of the ETF structure to another group of investors – namely, those looking for active management. Yes, traditional active managers such as Legg Mason and Eaton Vance are likely using this opportunity to participate in the move toward ETFs and to continue keeping revenues inside their firm, albeit in a different product instead of a mutual fund. However, that’s not the sole motivation of all potential entrants to the active ETF space.

Disclosure: No positions in above-mentioned names.

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