Active ETFs: Not an oxymoron

Active ETFs have only been on the market for six years, but that’s been enough time to cause a stir in the marketplace.

In August 2005, Claymore Investments launched what it billed as the world’s first actively managed ETF, Claymore Canadian Financial Monthly Income. Since then, actively managed ETFs have proliferated. Horizons Exchange Traded Funds Inc. now boasts 18 actively managed ETFs—eight of which are available in advisor series—and two closed-end funds with assets of over $1 billion as of October 1.

“Going forward you will be able to purchase any active manager as a mutual fund or as an ETF,” suggests Reg Jackson, a VP and Portfolio Manager with National Bank Financial in London, Ont. To Jackson, ETFs are just another delivery mechanism.

Claymore converted its inaugural active income ETF to a passive index in 2009, but re-entered the active space in March 2011 with the actively managed Claymore Advantaged Short Duration High Income Fund ETF, which now has $160 million in AUM.

Advisors should be watchful for differences between active and passive ETFs. ETFs have lower MERs and are generally more tax-efficient than mutual funds. However, what you’ve come to expect from passive ETFs when it comes to portfolio and pricing transparency is not true of most active ETFs.

Cost

MERs on active ETFs made in Canada range from 0.43% to 1.24% (advisor-class ETFs excluded). This compares favourably to no-load F-class mutual funds with MERs broadly spanning 0.50% to 1.85%.

Yet, as Dan Hallett, vice president of HighView Financial Group, notes, commission and bid/ask spreads on ETF trades need to be factored into the overall cost of an ETF.

“Quite a few active ETFs in Canada have performance fees, a layer most other products don’t have. In some cases, the benchmark used in the performance fee calculation is a mismatch relative to the actual mandate.”

Hallett cites Horizons Alphapro North American Value ETF as an example. It has a North American mandate but it is benchmarked to the S&P 500, which only tracks American stocks. A Horizons representative stated HAV has “historically had very little exposure to Canada.” Also, only six out of the 18 actively managed ETFs at Horizons have performance fees associated with them.

Claymore’s single active ETF has no performance fees.

Tax efficiency

Because they are exchange-traded, ETFs don’t sell their holdings to fund redemptions. This feature is inherently tax-efficient and both passive and active ETFs enjoy this advantage. Apart from this, Hallett notes, active ETFs are no more or less tax-efficient than actively managed mutual funds of a similar age, trading frequency and mandate.

There are, nevertheless, tax-efficient active ETFs. Stephen Verbeek, an investment advisor with RBC Dominion Securities in Hamilton, Ont., points out the covered-call writing active ETFs in the Horizons family are highly tax-efficient. He uses one gold-based yield fund, which gives his clients tax-advantaged income from an asset class that typically doesn’t provide cash flow.

He’s converted his clients’ gold holdings into this fund, thereby generating them 6.5% annual income. Horizons expects initial distributions will consist primarily of return of capital. It’s currently a closed-end fund expected to convert to an ETF by July 31, 2012.

Portfolio transparency

Passive ETFs publish their portfolios daily. This is seldom true of active ETFs: most active managers want to keep their trades under wraps to prevent front-running and freeloading. Horizons publishes its complete actively managed portfolio holdings every month.

Similar to mutual funds, Horizons is required to disclose the top 25 holdings on each fund on a quarterly basis, and the entire portfolio semi-annually. Horizons discloses the underlying portfolio on all of its actively managed ETFs to its market makers on a daily basis to ensure tight bid/asks to NAV are maintained throughout the day. Claymore publishes its sole active ETF portfolio daily.

Pricing

Without knowing the net asset value of an ETF, it’s not possible to determine whether you are buying at a premium or a discount to the underlying basket. In Canada, only Horizons Betapro and Index ETFs and Claymore ETFs have intraday NAVs available.

In the U.S., each ETF’s NAV is updated every 15 seconds. “In Canada we are running blind,” says a B.C. advisor. “The ETF companies [for the most part] insist on posting end-of-day NAV value only.

“With a mutual fund,” he adds, “I’m getting an end-of-day price with no bid/ask spread. An unpopular ETF will have a big bid/ask spread. Lower management fees, yes, but what if there is a half percent spread?”

Horizons’ senior vice-president of national sales, Faizan Dhanani, says their intention is to report the actively managed funds’ intraday NAVs in the future. Claymore’s fund intraday NAVs are available on Bloomberg and Thompson feeds, and Dan Rubin, Claymore’s vice-president of marketing, says NAVs should be on Claymore’s website before the end of 2011. The Claymore website currently provides only end-of-day NAVs.

The freedom of anonymity

Despite pricing irritations, our anonymous advisor uses Horizons Seasonal Rotation ETF because he likes the unique approach of capturing historically demonstrated seasonal trends, and he’s happy to find this in an exchange-traded product for one reason: the lack of pressure from sales reps.

“The mutual fund industry sells its funds with relationships,” says the B.C. advisor. “I need to keep one step away from them.”Also, mutual fund trades cannot be anonymous. With an ETF, the advisor can make the trade without identifying his office, and without short-term trading fees.

Donna Green is a New Hampshire-based finance writer. She co-authored The New Investment Frontier III: A Guide to Exchange Traded Funds for Canadians (2005) with Howard J. Atkinson.