Managers gently slipping into active equity territory

Active management goes against the grain for exchange-traded funds (and fund flows in general), which have favored indexed strategies. As of Dec. 31, there were 169 active ETFs holding $30 billion in assets, yet only $4.1 billion of that was held across 64 equity and multiasset products, according to XTF.

U.S. ETFs closed the year with $2.78 trillion in assets across 1,943 products.

For active equity strategies in ETFs, participation by traditional mutual fund managers has been non-existent, but that could be about to change.

In early January, large-cap equity specialist Davis Advisors is set to launch both a U.S. large-cap ETF and a financial ETF that will have daily-disclosed concentrated positions — 15 to 35 securities — at initial expense ratios of 0.6% and 0.65%, respectively. Including a diversified world equity ETF at 0.65%, Davis has said the firm expects to invest up to $15 million in each fund over the first year in operation.

“We think we're uniquely positioned based on our investment discipline — supporting long-term investors with low turnover, and also our culture, to offer our services through ETFs,” said Christopher Davis, chairman of Davis Advisors, which manages more than $25 billion across mutual funds, annuities and separately managed accounts. “It's amazing that such a huge gap exists,” he said, referring to the paucity of active ETFs in the market. 

As to concerns that a fully transparent product will reveal movements and positions that contribute to the potential for front-running, Mr. Davis said information related to his firm's investment positions is already in the marketplace through separately managed accounts. Also, referring to trading large-cap equities, he doesn't believe the ETFs' activity would have significant impact on the underlying securities.

In August, Vanguard Group, which manages $611 billion in 70 U.S. ETFs as separately traded share classes of existing mutual funds, filed with the Securities and Exchange Commission to offer transparent ETFs on a stand-alone basis. (Vanguard had filed for non-transparent active ETFs as a share class in March 2014.) The company did not disclose which strategies it might launch in the U.S.

“I suspect that Vanguard is teeing up a suite of actively managed, single-factors ETFs, similar to those that have been launched in the United Kingdom and Canada,” said Ben Johnson, director of global ETF research for Morningstar Inc., Chicago. 

The four products in each jurisdiction, launched in December 2015 and this past June, respectively, are managed by Vanguard's U.S. quantitative equity group and select stocks primarily from the FTSE Developed All Cap index based on relative liquidity, minimum volatility, momentum, and value. (The volatility ETFs hedge their currency exposure.)

Among Vanguard's competitors at the top of ETF league tables, BlackRock (BLK) Inc. (BLK) closed its four transparent active equity funds, marketed as “enhanced” strategies, in August. And State Street Global Advisors offers three active equity ETFs, subadvised by Massachusetts Financial Services. Launched in January 2014, the ETFs cost 0.6% and have only $20 million in assets under management in aggregate.

Nick Good, co-head of State Street Global Advisors' Global SPDR business, points out that the underlying liquidity constraints for equity ETFs, not to mention the shift from traditional “benchmark hugging” active mutual funds, will continue to pose a challenge for active equity managers.

“I don't think this market will develop the same way that the mutual fund business did,” said Mr. Good. 

Legg Mason (LM), which offers six ETFs based on quantitative indexed strategies, has also filed to offer transparent equity ETFs.

While other equity fund managers have indicated support for various forms of non-transparent equity ETFs that have not yet come to fruition, Fidelity Investments revealed plans in August for yet another approach at a limited disclosure exchange-traded product. 

Like the NextShares structure promoted by Eaton Vance (EV) and adopted by Ivy Funds and GAMCO, the Fidelity non-transparent active proposal would not fall within the definition of exchange-traded funds — i.e. '40 Act products with daily share creation and redemption by authorized participants along with secondary market transactions on securities exchanges.

Dubbed exchange-traded active funds, the Fidelity-proposed product would reveal its portfolio monthly, with a monthly lag, and publish daily a portfolio of recently disclosed stocks and reference ETFs that could be used by the market to approximate the full portfolio. 

Having ignored ETF market developments for more than a decade, Fidelity has expanded its ETF offerings and intentions in the past three years.

“Fidelity has gone from just hoping that ETFs would go away to taking a kitchen sink approach,” said Morningstar's Mr. Johnson.

This article originally appeared in the January 9, 2017 print issue as, "Managers gently slipping into active equity territory".