Firms say active ETFs finally getting respect

After years of marketing actively managed exchanged-traded funds to institutional investors to no avail, money managers believe they're finally at a tipping point.

Not only have managers like Pacific Investment Management Co. LLC and State Street Global Advisors seen their active ETF assets grow over the past year, but with Fidelity Investments and Vanguard Group Inc. now looking to get into the game, it appears as though these once niche vehicles might soon gain acceptance from institutions.

Natalie J. Zahradnik, executive vice president and ETF strategist in PIMCO's Newport Beach, Calif., office, said in a phone interview that her firm has seen “an increased interest and acceptance among institutional investors” in active ETFs.

PIMCO is now the largest purveyor of active ETFs; it reported $7.8 billion in active ETF assets in the U.S. as of June 30, up 8.3% from Dec. 31. PIMCO has 13 active ETFs, seven in the U.S. and six in Europe.

Looking ahead, Ms. Zahradnik said she expects “an increased adoption” of active ETFs among institutional investors.

Data from Morningstar Inc. show that actively managed U.S. ETFs had $26.17 billion in assets as of June 30, up 32% in a year.

Institutional investors and money managers alike have been skeptical about allocating money to — or providing — active ETFs. Asset owners seeking active management have historically been able to exercise significant discretion on price and strategy through commingled vehicles or separate accounts. And a Securities and Exchange Commission requirement that active ETFs provide daily transparency has also stalled widespread adoption.

“Perhaps the biggest challenge is (active ETFs) require daily transparency of portfolio holdings,” said Stephen Clarke, president of NextShares Solutions LLC. “Most active managers are unwilling to do so because it can compromise their trading objectives for their clients.”

But with firms like NextShares and Fidelity finding ways around the transparency issue — NextShares already offers non-transparent exchange-traded managed funds and Fidelity is looking to offer non-transparent exchange-traded active funds — and investors wanting cheap alpha in today's current volatile and low-return environment, active ETFs aren't looking quite so bad these days.

“ETFs have structural advantages,” Mr. Clarke said. “They tend to have lower operating costs, tend to minimize flow-related costs and tend to have low cash balances.”

Tim Barron, Chicago-based chief investment officer at Segal Rogerscasey, also noted that transparency may be a hindrance to active ETFs. “That may make some managers squeamish about issuing active ETFs, because they may not want to publish that slice of their portfolio,” Mr. Barron said.

He added that although an investor can buy an active ETF without needing an investment management agreement, investors should also be asking if the ease of access and the ability to be tactical and make asset allocation changes much more simply offsets the challenge of transparency.

Mr. Barron also posed the question: “Is the reduction in friction significant enough to offset what may be higher costs?”

In August, Malvern, Pa.-based Vanguard asked the SEC for permission to market active transparent ETFs.

“We believe that we can provide a greater number of investors with low-cost access to active management expertise through an ETF,” said spokesman David Hoffman. “Vanguard also believes that low-cost diversified strategies are keys to success with active management. ETFs will open up a distribution channel for investors to gain access to our active management exposure.”

Fidelity also petitioned the SEC in August to approve the Boston-based firm's non-transparent exchange-traded active funds. Spokeswoman Nicole Goodnow said the ETAF intends to deliver “the desirable features of an exchange-traded product, including flexibility to trade on an exchange, real-time pricing and possible tax efficiency combined with the alpha potential of Fidelity's active investment management capabilities” through “a non-transparent exchange-traded vehicle.”

David B. Mazza, a managing director of State Street Global Advisors and the head of ETF and mutual fund research in Boston, said that although the firm launched its first actively managed ETF in 2012, it wasn't until 2015 that active ETFs garnered a significant amount of attention among institutional clients.

“The industry is maturing. Investors are looking at the benefits of the ETF structure: its tax efficiency, transparency and liquidity,” Mr. Mazza said. “Now, managers are looking to deliver their strategies to institutions through ETFs. So there are certain strategies, like investment-grade fixed income, for example, that are ripe for active ETFs.”

The SSgA executive also pointed out that when returns are structurally lower and volatility is likely to be higher, investors tend to focus more on what they can control. And one thing they can control is cost.

“When an investor can build a diversified portfolio and save money to get alpha, it's very beneficial,” he said. “In many cases, the ETF vehicle comes in a low-cost structure.”

SSgA has a total of 272 ETFs, 12 of which are active. The manager had $3.94 billion in active ETF AUM as of June 30, up 32.2% from Dec. 31.

Tom Hoops, head of business development at Legg Mason Inc., said that although the Baltimore-based manager hasn't yet seen widespread adoption of active ETFs among institutional investors, it's not only on its way, but also Legg Mason is prepared for the interest.

“They're kicking the tires. They're looking at scale,” he said about how asset owners are starting to regard active ETFs. “We believe the adoption will ultimately come.”

Legg Mason's Mr. Hoops noted that “in an environment of low rates and lower expected rates of return, costs matter.” Since an actively managed ETF typically costs less than an actively managed mutual fund, active ETFs are starting to gain acceptance among institutions.

He added that Vanguard and Fidelity looking to market active ETFs is “additional confirmation of our view that more and more people are thinking that the vehicle will be relevant outside of just pure indexing.”

Legg Mason filed and received exempted relief to market ETFs, but only in smart beta so far. Although Legg Mason hasn't yet launched active ETFs, Mr. Hoops said that the firm needs “to be prepared to offer many of our active strategies in an ETF wrapper.”

Justin R. White, a principal at money management consulting firm Casey Quirk by Deloitte, Darien, Conn., said it could be possible that the active ETF wrapper could play a bigger role in active management going forward. “The question is, how quickly will the market adapt to active ETFs?” he mused. “How important are lower costs and tax efficiencies to investors, and how big is the difference between an actively managed ETF vs. a mutual fund going forward? The jury's still open there.”

The other big question determining the growing popularity of active ETFs, according to Mr. White, is importance of intraday trading to investors.

“The ETF wrapper is one lever firms are considering, but there are quite a few others,” he said, citing factor-based investing and multiasset class solutions as examples.

“In some way it's like putting last year's gift in a new box and saying it's a better gift this year,” Mr. White said. “Does the wrapper solve this or not?”