Active exchange-traded funds have seen record inflows in recent years, taking assets under management to $630 billion. That’s a lot of money but small in comparison to the $10 trillion in ETF assets overall or the $24 trillion in public mutual funds registered in the US. Still, one corner of the active ETF space represents the best shot traditional fund managers have of preserving their role in the investing landscape.
Active ETFs are mainly new distribution mechanisms for existing strategies. Almost all are linked to active public mutual funds—conversions (the public mutual fund is changed to an ETF), clones (an ETF with the same strategy and portfolio as the public mutual fund) or new share classes for an existing fund. These have little effect on the asset managers, only on the plumbing that connects them to investors. A few active ETFs are strategies launched specifically for this space, but they are not very different from active public mutual fund strategies.
The place to keep your eyes is on a tiny sliver—less than $10 billion AUM—of the active ETF market: the semi-transparent and nontransparent ETFs exempt from daily portfolio disclosures. Opinions on these funds are sharply divided. ETF.com has declared them to be the “holy grail” of the asset management industry, though tepid early interest has led others to dismiss them as out of step with the transparency investors demand today.
It seems too early to write off these secretive ETFs with most large fund managers having either issued such products or announced plans to do so, including JPMorgan & Co., Blackrock Inc., Legg Mason Inc., Gabelli Funds, Columbia Threadneedle Investments, Nuveen and American Century Investments. If these take off, they could cause fundamental changes to the asset management industry, giving managers a more prominent role and potentially arresting the Quicktakelong trend toward lower fees.
A little history. The modern public mutual fund was created by the 1940 Investment Company Act. All these funds were actively managed until the early 1970s when the U.S. Securities and Exchange Commission approved the first public mutual index fund. ETFs reversed this process, beginning life in 1993 as index funds, with active management only approved in 2008.
Transparent active ETFs, which still make up 99% of the active ETF space, were severely constrained by the need to disclose holdings daily. This was unacceptable to most managers trying to beat markets both because it revealed secret sauces and invited hostile trading. Public mutual funds are only required to disclose holdings quarterly, with a 60-day delay.
Getting around that obstacle was tricky. ETFs rely on position disclosure so that authorized participant market makers can keep the ETF price in line with assets. A complex workaround was needed before the SEC approved semi-transparent and nontransparent active ETFs in 2019, and they have only recently begun to attract assets.
Why are these ETFs a holy grail if they are only poised to cannibalize assets from other vehicles?
The trend driving change in the asset management industry for years has been fee compression. The willingness of investors to pay loads and fees has steadily declined. Funds are seen increasingly as commodity products, and investors seek out the cheapest ones. An ETF that publishes its portfolio of assets daily is a commodity. Investors are not hiring a manager, they’re buying a basket of stocks, and they’re generally unwilling to pay large fees for that.
Actively managed public mutual funds have been in decline for nearly two decades. Yale School of Management professor Roger Ibbotson predicts their share of total fund assets will drop to 17% over the next 12 years from 97% in 1991. Moreover, the highest-fee funds are declining fastest, leading most to slash fees. Another problem is a smaller AUM means the fixed expenses of running funds eat up more of the revenue.
So far, investors in ETFs seem less fee-sensitive. For one thing, ETFs generally have lower fees and many investors enjoy tax advantages. ETFs allow more sophisticated strategies. They are also cheaper to run, so even the same fees as public mutual funds can mean greater profits. Semi and non-transparent ETFs are not commodity products — they cannot be easily duplicated. Buying one represents a bet on a manager rather than an opinion about a basket—harking back to the good old days of fund management.
It’s too soon to evaluate the performance of semi and nontransparent ETFs; there aren’t enough of them, and track records are too short. At least some of these funds will have to demonstrate a sustained and significant ability to beat markets to attract investor inflows.
There’s a long road before semi and nontransparent ETFs transform the asset management industry, and many forks that could lead to a different result. But there aren’t many hopes on the horizon that could reverse asset management fee compression, making this a quest worth pursuing even if it ends up being a Hail Mary pass.
Aaron Brown is a former head of financial market research at AQR Capital Management. He is also an active crypto investor, and has venture capital investments and advisory ties with crypto firms.