Active ETFs: Why and why now?

Active exchanged-traded funds (ETFs) are the investment du jour, with asset managers scrambling to offer them to their clients. There are a multitude of reasons for this, but they boil down to a virtuous circle of three:

1. Scalability
2. Efficiency
3. Cost

The impact of scale

Historically, investors outside the US have had access to various types of collective investment schemes, depending on their domicile and the underlying asset exposure. UCITS were originally designed to create a single marketplace for funds in Europe. However, their exchanged-traded offspring, UCITS ETFs, have become widely accepted not just in Europe but across the globe, including in Asia and Latin America.

The growth potential of UCITS ETFs is huge, the market is worth an estimated US$11-12 trillion – roughly the size of the European UCITS market if you exclude ETFs. However, the opportunity for UCITS ETFs isn’t just about converting existing European UCITS investors to the ETF format. It’s about the ability to access a global marketplace, potentially in the region of US$100 trillion when you consider the size of global fund assets. This opportunity to scale is available for UCITS ETFs in a way that traditional UCITS funds can’t.

For fund managers, the ability to access a global investor base with a single vehicle has clear advantages. But why should investors care? The primary reason is that economies of scale translate into lower fees, and therefore into higher net returns. There is also a secondary benefit. A global investor base can drive the development of a far broader range of exposures and funds, putting more interesting options into every investor’s toolkit.

Transparency brings clarity

ETFs have a reputation for efficiency and transparency. But what does that mean in practice? Pricing is a case in point. ETFs are priced with a total expense ratio (TER) that includes both operational costs and management fees. While traditional funds also state a management fee, the investor is faced with additional costs that are only revealed after they invest.  If we assume 0.10% per annum of operational costs (for many funds this figure can be much higher), then a TER of 0.35% on an ETF is roughly equivalent to a management fee of 0.25% on a traditional fund. More importantly, the investor knows – on the day that they invest – exactly how fund costs may impact future performance. What’s more, ETFs have created a democratic environment: every investor, whether large or small, gets access at the same price.

This cost transparency extends to trading too. When investors in UK and Irish-domiciled traditional funds give an investment instruction, they are told the net asset value (NAV) and possible swing pricing (which aiming to protect other investors from absorbing costs from the trade) after they’ve traded. In contrast, an ETF investor is given a bid/offer price at the point of trading, enabling them to make a more informed decision whether to trade or not.

Information is very easy to find. ETF websites give daily information around NAV, holdings, yields and performance. Although UCITS regulation doesn’t specify the exact information that providers should disclose, the standardised mechanics of UCITS ETFs, combined with a highly competitive markets, mean that most ETF product web pages look very similar.

Scale brings even more efficient trading

A unique feature of the ETF market – and a key driver of efficiency – is the relationship between primary and secondary markets. ETFs are exchange-traded securities with a secondary market where investors can buy or sell. However, ETFs are also open-ended funds with a primary market where units can be created and redeemed.

This primary market is restricted to Authorised Participants (typically large brokers) but still provides huge benefits for investors. When an investor is looking to trade an ETF, their worst-case scenario is that there are no other buyers or sellers in the market. In this case, an Authorised Participant has to access the primary market to create or redeem units and the bid/offer presented to the investor is generally based on the bid/offer for the basket of underlying assets held by the ETF. But remember, that’s the worst case.

As the ETF gets larger and more popular, the bid/offer price tightens relative to the primary market because many secondary trades will not trigger a primary market transaction. For the largest ETFs, the bid/offer is often a fraction of the average bid/offer for the securities that the ETF holds. Again, scale is driving efficiency and cost savings. Investors see this virtuous liquidity circle in all highly liquid basket instruments like futures and CDS indices. This is what makes ETFs useful both for long-term investment and short-term ‘equitisation’ of cash – i.e. gaining market exposure while you decide your longer-term plans.

In summary – UCITS ETFs are attractive to investors because:

• The buyer base is increasingly global, offering economies of scale to the fund and in the secondary market pricing
• Investors buy at an agreed price with a fixed total cost of ownership
• Investors can buy or sell daily at a bid/offer that can be significantly tighter than the bid/offers for the underlying assets and is executed in one trade through a competitive process
• Information about an ETF’s pricing and holdings is available daily on the provider’s website

What does this mean for active ETFs?

Firstly, the transparency and efficiency of ETFs allow active investors to focus their attention on the performance of the fund manager in delivering on their stated objectives. It’s very clear what the investment is costing to hold and what it would cost to buy or sell. If the investor is not convinced by the performance of the fund, they can easily sell and try another approach. This is good news for active managers with compelling high impact solutions, although less good news for managers that struggle to beat the benchmark.

Secondly, active ETFs are a great way to offer exposures that are missing from investors’ portfolios but difficult to deliver passively. This explains why AAA CLO ETF exposure has been well received by investors in the US. The need was there, and the value proposition was relatively easy to understand. All that was missing was the right vehicle for gaining the exposure. The combination of an efficient, tradeable ETF wrapper and an experienced CLO manager looks to be a great solution. The most successful product launches tend to be those where a fund manager can provide a clear solution to an investor problem.