There has been much speculation as to when actively managed exchange-traded funds will accelerate the shift away from open-end mutual funds.
Strong growth in asset levels shifting to ETFs has been well documented over the last several years, with monthly and annual statistics and commentary on the asset outflows from open-end mutual funds and inflows into ETFs. A significant percentage of those inflows has been into passive ETFs, which are based on a static index portfolio of securities rather than active portfolio management.
The assets in actively managed ETFs, however, still hover in single digits as a percentage of total ETF assets. Most observers believe the hesitancy of active portfolio managers to either start a new ETF or shift their open-end fund assets into an ETF stems from the requirement to disclose a full listing of the ETF portfolio every day. Most portfolio managers understandably do not want to give away their intellectual property and insight into their methodologies, the primary source of their livelihood.
Semi-transparent or non-transparent ETFs, approved in concept and structure last year, may change that paradigm. These structures allow the ETF manager to provide a portfolio "basket," used by market makers and in the process of ETF share creation and redemption, to "mask" some or all of the ETF portfolio, preserving the intellectual property of the portfolio management team. The models that have thus far been approved by the SEC for use in ETFs range from very opaque to fully transparent in the securities in the portfolio, while masking the percentage allocations.
The structures are still some time away from being marketed, as actual ETFs using the structured processes remain in registration. Several ETF issuers and white-label fund administrators are pursuing the process of registration to make the active non-transparent structures available in 2020. When these structures become more prevalent, it seems very likely that open-end mutual fund portfolio managers and other active investment managers with the ability to distribute an ETF effectively will move to register their own active non-transparent ETFs.
It seems investment adviser platforms, designed to transact and hold securities for wealth management professionals and their clients, are anticipating such a shift in the vehicles of choice. Zero-transaction-fee programs, which swept the wealth management industry in 2019, make ETFs a very favorable investment vehicle for achieving portfolio allocation. Low-to-no trading costs, ease of entry and exit by trading on the stock exchanges like any common stock, and portability are all attractive benefits of using ETFs. While open-end mutual funds will still be almost equally easy to use, there are some built-in problems with how these funds are currently held.
As wealth managers moved to asset-based compensation from transaction-based compensation for the services rendered to clients, savvy investment platforms offered to provide reporting, performance measurement and other client service tools to investment professionals in return for holding those assets and transacting through the platforms. These platforms derived significant indirect compensation from the mutual fund companies, which have been paying them large onboarding fees and asset-based fees of up to 40 basis points. These fees have kept the expense ratios of open-end mutual funds artificially high, with the platforms frequently making as much or more on a net basis as the portfolio managers.
ETFs have already changed that paradigm, with their introduction leading to large asset shifts away from actively managed open-end mutual funds and into lower-cost passive index ETFs. As the investing public has become more comfortable with the ETF structure, ETFs have attracted $4.4 trillion in assets. Of those, less than 3% were actively managed ETFs as of the end of 2019. Actively managed non-transparent ETFs should dramatically shift that balance over the next few years, with most observers expecting actively managed ETFs to outpace new filings for passive ETFs.
A final piece to the puzzle in what could be a major shift from open-end mutual funds to ETFs will be the retirement plan markets. Qualified plan assets are a sizable portion of mutual fund assets. Most retirement plan administrators have well-oiled systems for taking employer and employee contributions through payroll processing, moving the contributions into mutual fund positions and accounting for the qualified plans using electronic feeds and pricing systems. The retirement plan industry is understandably comfortable with the status quo, as it works quite well.
As younger investors become an increasing percentage of the workforce, however, it is expected there will be more demand for ETFs in retirement plans. Younger investors are used to mobile data and checking prices and other data feeds on demand. ETFs are far more in line with this thought process than open-end funds, which are priced only at the end of each day. As demand drives more retirement plan administrators to open 401(k) plans to include ETFs, there could be a significant shift from open-end funds to ETFs.
Kip Meadows is the founder and CEO of Nottingham, a fund administration firm and white-label ETF issuer based in Rocky Mount, N.C. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.