ETFs Advantages vs. Mutual Funds
Of late, there has been an increase in use of exchange traded funds, a much more investor-friendly alternative to mutual funds. ETFs have traditionally been viewed as an alternative based on their cost efficiency. For instance, there are no minimum amounts required to invest in the funds, save for the price of one share of an ETF. This goes hand-in-hand with another benefit; the potential for high diversification with very low sums of money.
Because of the advantage of intraday trading, these funds can be bought easily over an online brokerage account, thereby keeping transaction costs on the same low levels as online equity trades. This opens the door to investors interested in dollar-cost-averaging, and makes it just all around easier to invest by ways of bypassing the need to contact a fund provider. The ability for options on ETFs is also a driving force, as well as the possibility of holding short positions – both impossible with mutual funds. Stop and limit orders also give another element of trading unavailable with mutual funds.
Most of all, though, the driving force behind ETFs have been their low cost due to passive management. However, for those who believe in the advantages of active management, the hype about ETFs may simply seem to be much ado about nothing.
Emergence of Actively Managed ETFs
Though they have yet to gain widespread popularity in the industry, actively managed ETFs combine the convenience of secondary trading with the advantages of active managers. Active management within such close reach to retail investors is a major leap towards a more investor-friendly market.
However, the advantages of actively managed ETFs are not completely one sided. Compared to a mutual fund, there are also many advantages in active ETFs for managers as well. Since shares of ETFs are traded on a secondary market, the ETF advisor does not keep records or service the current shareholders. This does make management a little bit cheaper. In addition to this, the advisor will never have to deal with new subscriptions or redemptions. The risk of having to make abrupt trades to meet demands in short-term cash requirements for redemptions is eliminated. Also, there is no risk of enormous inflows of money which could, at some times, cause a fund to become cumbersome for small management teams. These hassles range from annoying to potentially very costly, and are all eliminated in actively managed ETFs.
Structure of Active ETFs
Another major advantage of ETFs is transparency, something very valued in the post-Madoff world of investing. Holdings of ETFs must be disclosed at the end of each day. This very feature, however, has also been the reason why ETFs have traditionally been associated with index investing rather than active investing. The concept of actively managed ETFs has traditionally been overlooked since an advisor typically would not want to disclose his holdings to the public. This would open the door for managers’ strategies to be copied and could also allow traders to figure out major market moves. Traders could take advantage of this by engaging in the unethical practice of front running, or making their own trades (and therefore running prices up) before the advisors’ trades are executed.
One of the ways to counter this is used by Grail Advisors in their Grail American Beacon Large Cap Value ETF (NYSEARCA:GVT). It is structured by having three sub-advisors whom which they allocate a portion of the assets under management. This is very similar to a manager of managers approach. While the assets still must be disclosed, breakdown between each sub-advisor is not required, thereby casting some fog over the advisors’ moves.
Grail has also found managers willing to take up the challenge of being stand-alone advisors for their active ETFs. Some of these funds are the RP Focused Large Cap Growth ETF (NYSEARCA:RWG), and the RP Technology ETF (RPQ). PIMCO, which has three active fixed income ETFs, Enhanced Short Maturity Strategy (NYSEARCA:MINT), Intermediate Muni Bond Strategy (NYSEARCA:MUNI), and Short Term Municipal Bond Strategy (NYSEARCA:SMMU), has a strategy to only hold assets which are liquid enough to sell within one day. This prevents traders to engage in intraday front running.
Potential Change in Regulation
Not long ago Bloomberg reported that BlackRock, which already has one actively managed ETF, the iShares Diversified Alternative Trust (NASDAQ:ALT), is seeking approval from the SEC for actively managed ETFs that would keep some information on their asset listings undisclosed. This could come by extending the disclosure periods to longer then a day (Canada requires ETFs to only disclose their holdings once a month), requiring only the top holdings to be disclosed, or not requiring weights to be assigned to the disclosures. Any of these would still keep active ETFs a much more transparent alternative to mutual funds, which are only required to disclose their holdings once a quarter, with a 30 day lag.
There are about 30 actively managed ETFs already on the market, but only a handful are truly active, without any trading restrictions placed on them. However, investors should expect to see many more actively managed ETFs in the years to come, especially if we see a change in SEC regulation. Even without this regulation change, the move towards a more convenient product should be expected in the ever-more investor focused investment product universe.
Disclosure: No positions