Thoughts on Active ETFs

By Matthew Hougan

I spent most of last week talking to people about actively managed ETFs. Reporters, investors, product developers ... everybody was in a tizzy about the new developments.

I'm excited too. We spent most of Friday getting to the bottom of what was really happening with the active ETF filings: who was really ahead; what stumbling blocks remain; when we can really expect the first funds to launch.

I think we're close. I think it's a matter of crossing a few "t's" and dotting a few "i's". And that's exciting.

But I also think that, once these products launch, much of the excitement will fade away.

Don't get me wrong. As I've said before, the advantages that ETFs hold in the index world - lower expense ratios, more tax efficiency - are amplified in the active space. The tax efficiency advantages alone will be huge, amounting potentially to a 1-2% after-tax advantage for the average ETF over the average actively managed mutual fund. In the active space, ETFs really are a better mousetrap.

But there's a catch. Actively managed mutual funds are sold by two tactics: commissions and past performance (aka, Morningstar Five-Star Ratings).

Unfortunately, neither of those tactics applies to the new ETFs. No one has figured out how to attach a commission to an ETF, although many have tried. And because the funds launching are new funds, they do not have past performance records to go on.

No commission plus no performance record equals no assets, at least initially.

I hope I'm wrong. Based on the numbers, it's clear that a lot of investors want to buy actively managed mutual funds, and I'd rather they do it in a low-cost, tax-efficient package.

But what we've seen in the ETF industry is that the most successful ETFs are the ones that have launched into latent demand, and I'm just not sure that that demand exists for new actively managed funds with no track record.

Long-term, this industry is a winner. But short-term, I think it will take some time for these new funds to get off the ground.

Comments

[PR]

How are these products more tax efficient? Is the turnover going to be less than most mutual funds?

Aside from the well managed index products, most mutual funds still have extremely high turnovers (more than they realistically should) and generate cap gains equal to 50 to 70% of annual appreciation that is then distributed as dividend.

[veeblefetzer]

I think you're right that most of the excitement will fade away. Actively managed funds by their nature have more turnover than index funds and therefore are less tax efficient, and in the long run don't do any better. There are plenty of actively managed mutual funds, some with relatively low expenses, for those who prefer active management, so I'm not sure who these funds are aimed at.