Active ETFs represent huge growth market: Study

Only a handful of actively managed exchange traded funds (ETF) exist today, but a new study from the Boston-based Financial Research Corporation (FRC) suggests active ETFs are a credible threat to overtake traditional mutual funds.

ETFs are synonymous with index-linked performance, which is passive investment management by definition. But they don’t have to be passive strategies. Active mandates found among most popular mutual funds can theoretically be replicated in the ETF structure, which trades on a listed exchange.

With five active actively managed ETFs now available in the U.S. — all offered by Invesco Powershares — and a handful available in Canada by a couple other providers, FRC predicts in its new study, Actively Managed ETFs: Competitive Threat or Passing Fad?, that it’s only a matter of time before use of the product grows exponentially.

In 2000, FRC offered a similar study where it surveyed early adopting advisors regarding their predictions for the ETF marketplace. At the time, respondents predicted ETFs would capture one-quarter of index assets by March 2005. FRC found that ETFs met this mark by March 2003, and by March 2005, the products controlled nearly one-third of index assets.

“In 2007, U.S. ETF sales rivaled the sales of mutual funds. In 2008, ETFs posted $182 billion in new sales, versus outflows of $160 billion for mutual funds,” says Rob Ivanoff, and ETF research analyst with FRC. “ETFs have been posting 35% annual growth rate in the last ten years, which in our opinion makes them the fastest growing global product in the last few years.”

ETF structure offers diversification advantages

The study finds the preference for index-linked ETFs does not necessarily stem from their passive strategy. The primary reason investors opt for ETFs is that they allow sector-targeted exposure. The second most popular reason is cost-savings, according to the study.

This suggests fans of active management would likely use active ETFs for their cost savings and diversification features.

“ETFs allow much more flexibility than mutual funds allow. You can hedge, short and borrow ETFs. You can basically trade this product,” Ivanoff says. “We think that financial advisors who use active managers will be directly aligned with this product. An actively managed ETF structure is much more transparent, so it will be much easier to identify management talent and all these ratios they have run to see how risky the fund is for one period over another. In fact, when we polled our advisors, already 48% of them believed [active] ETFs would gain traction and replace active mutual funds.”

Ivanoff says the cost savings on an actively managed ETF is substantial. An investor who buys an active ETF with the same mandate offered in a mutual fund trust structure, could see cost savings between 30 to 50 basis points.

Why aren’t active ETFs already prevalent? One reason is that it takes up to two years to get them approved by the U.S. Securities and Exchange Commission. So only the very early entrants have been approved. Ivanoff says it takes about three years of performance until institutional investors will start to feel comfortable with a product.

“The biggest cost of bringing an active ETF to market comes from gaining exemptive relief with the SEC. The waiting period is a year to two years. Once a pattern has been established between the SEC and the firms that are filing for this product, the distribution will likely be client driven,” he says. “The U.S. retirement space will be popular; the 401k plan users have shown a preference for active management. The only way you can decrease costs on those plans is with ETFs. Their preference is for active management but at a reduced cost, so we think it’s a big market opportunity for the active management ETF space.”

Active ETFs make inroads in Canada

One of the biggest proponents of the active ETF structure in Canada is BetaPro Management. The firm has a sister subsidiary called AlphaPro Management which recently launched the Managed S&P/TSX 60 ETF, an actively managed mandate which uses the investment models created by Ron Meisels, president of Phases and Cycles.

Howard Atkinson, BetaPro’s president says his company also intends to convert its closed end AlphaPro Gartman Fund into an ETF, because the structure is the most cost-efficient way to offer active management.

“With mutual funds in Canada the average cost is 250 basis points. We would argue in an apples-to-apples comparison, where you put an ETF in an account where the investor is using an advisor, you’re probably seeing somewhere between 60 to 100 basis points cost difference,” he says.

“If you rank all active money manager performance at the end of period, whether it’s a year, five years or ten — some will beat the index. History suggests most of them won’t. One of the major reasons for that is the fees cause them to underperform. If you lower those fees, some of those managers that didn’t quite outperform the index will pop out on top of the index. You should have more active managers outperforming the index if you have lower fees.”

ETFs already dominate the market share of passive management by a margin of three to one, in comparison to index mutual funds, Atkinson says. If active ETFs were to gain the same traction, they would be encroaching on roughly $400 billion of Canadian mutual fund assets, viewed as actively managed.

“At the beginning of the decade if we looked at just indexed mutual funds versus ETFs, you have approximately three times more assets in index mutual funds, versus index linked ETFs. If you look at the numbers today, it’s almost exactly the opposite. The numbers today are $22 billion in ETFs versus $7.8 billon in index funds,” Atkinson says. “This suggests investors prefer ETFs versus mutual funds as a delivery mechanism for a portfolio.”

(04/24/09)