What to Know About Actively Managed ETFs

May 18, 2012

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

Exchange-traded funds (ETFs) have a well-deserved reputation for giving investors exposure to the stocks or bonds in a broad market index at a low ongoing cost relative to some other investment options. Most ETFs do track indexes and tend to offer these benefits, but some ETFs fund managers have the flexibility to hold whichever securities they think are best for their shareholders. Such ETFs are said to be actively managed, and figuring out whether these ETFs make sense for your portfolio is a different process than evaluating index ETFs.

Degrees of activity

Traditional index ETFs are fairly straightforward. These ETFs generally track indexes by putting money into stocks of a particular type (large companies, small companies, certain countries, a certain sector, etc.) based on their total stock-market values. Companies whose total stock outstanding is more valuable will receive more weight. This is referred to as market capitalization weighting, or "cap weighting," and it's designed to measure market returns. Cap-weighted indexes don't require a lot of trading activity to manage, so they tend to be very low-cost and tax efficient.

Beyond traditional cap-weighted indexes are alternative index structures. These include ETFs that follow indexes built by giving equal weight to each stock in the index, using company fundamentals such as profits to weight the stocks relative to one another, or using quantitative metrics like momentum and valuation to build an index. These approaches attempt to add value above and beyond traditional cap weighting while still following a published list of stocks in an index. Alternatively weighted ETFs will typically have higher fees than traditional cap-weighted ETFs.

A true actively managed ETF tracks no index at all. The manager of the ETF can buy whatever stocks or bonds seem best, within the parameters of the ETF's prospectus. Sometimes this is a relatively minor degree of activity, such as deciding exactly which month of futures contracts to buy for a particular currency. Sometimes it's quite active, such as a stock manager with freedom to buy a wide range of different companies or a hedge-fund-like manager moving between stocks, bonds, commodities and currencies. These funds might outperform traditional market indexes, but they also carry the risk of performing worse than the market if the manager doesn't succeed in picking good investments. They also tend to have higher expenses than index ETFs.

The lay of the active ETF land¹

Currently, the vast majority of ETFs are index ETFs; only 47 out of more than 1,200 are actively managed. The existing active ETFs vary greatly in terms of popularity in the market.

The largest actively-managed ETF by assets is PIMCO Enhanced Short Maturity ETF, better known (as many ETFs are) by its ticker symbol, MINT. This ETF is managed by Pacific Investment Management Company (commonly called PIMCO). This fund has more than $1.5 billion in assets and invests in short-term bonds in an effort to provide investors with yield. The second-largest actively managed ETF is WisdomTree Emerging Markets Local Debt (ELD), which invests in bonds issued by countries such as Mexico, Indonesia, Brazil, Russia and China. These are the only actively-managed ETFs with more than $1 billion in assets. By way of comparison, there are 156 index ETFs with at least $1 billion in assets, the largest of which has more than $100 billion.

Only nine companies currently offer actively-managed ETFs:

• WisdomTree has eight emerging-market currency funds, three emerging-market bond funds, a European bond fund and a hedge-fund-like ETF.
• AdvisorShares has 13 ETFs with varying strategies (stocks, bonds, hedge strategies, mixtures) managed by a variety of advisors.
• PIMCO has six actively managed bond ETFs,
• Columbia Management has three stock funds and two bond funds.
• PowerShares has three truly active ETFs (in addition to their many quasi-active ETFs).
• Guggenheim Investments manages two active bond ETFs.
• iShares has a single hedge-fund-like ETF.
• Russell has a single asset-allocation ETF.
• State Street Global Advisors recently entered the active ETF market with three ETF fund-of funds. The holdings for these ETFs are other ETFs.

It's likely the actively managed ETF market will continue to grow. Several companies have filed paperwork with the Securities and Exchange Commission indicating that they're interested in launching more of these products. The development of the industry will largely be guided by the future of ETF regulation.

Transparency and active management

One reason there aren't more actively managed ETFs has to do with transparency. In order to do their jobs, market participants who are creating and redeeming ETF shares need to know what assets the ETF holds every day. With an index ETF, this usually isn't a problem; ETF managers are more apt to be comfortable telling the market what they hold, since the list of securities they may choose from is available in a published index.

Active ETFs are different because an active manager might not want to give up a competitive edge by telling the market exactly what the fund is buying and selling every day. Even if the ETF's positions would be announced a day later, this is still too much transparency for many active managers to be comfortable with. After all, the active manager's "special sauce" is the decision to buy or sell particular stocks and bonds, and the manager might not want the whole market to see these decisions right away.

Some managers aren't worried about this level of transparency, especially among bond funds, but many managers are. Unless regulators approve a structure that doesn't require full disclosure of an ETF's portfolio every day, some active strategies are unlikely to be introduced in ETF form.

PIMCO Total Return: Same as the mutual fund?

One actively-managed ETF that's garnered much attention in the industry is PIMCO Total Return ETF, which launched with the ticker symbol TRXT in March 2012 but later changed its ticker to BOND. This ETF shares the same name and portfolio manager as the largest mutual fund in the world, PIMCO Total Return Fund. Does this make it the same fund?

Well, that remains to be seen. The ETF is not a share class of the mutual fund; it's a separate pool of assets, managed by the same people using the same general strategy. The key difference lies in what the two versions hold. The mutual fund version can hold derivatives—things like interest-rate-swap contracts and bond futures—which allow it to manage hundreds of billions of dollars without having to trade massive quantities of relatively hard-to-trade bonds. The ETF version, on the other hand, is not permitted to hold any derivatives. Thus, it holds actual bonds.

Holding actual bonds is good in that the ETF will not have to worry about counterparty risk—that is, the risk that the investor on the other side of a swap agreement might not be able to make good on their end of the bargain (though credit risk from bond issuers is common to both versions of the fund). However, if the ETF's assets grow in the future, not being able to use derivatives might mean that the ETF's trading costs could be higher.

In addition, because ETFs trade like stocks, when trading an ETF, investors will have to consider the cost of commissions, the bid-ask spread, and any difference between the ETF's market price and its net asset value—none of which come into play for a mutual fund. On the other hand, the ETF does provide more trading flexibility without worrying about loads or redemption fees that can apply to mutual funds.

So, is the ETF the same as the mutual fund? No, there are differences. It's too soon to say how important these differences might be.

Evaluating an actively-managed ETF

Once you've picked a market segment, deciding which index ETF to buy can be a fairly straightforward exercise of looking for low cost. A low expense ratio, small bid-ask spread and zero commission (if possible) make for a compelling case, as long as they're combined with a large asset base and a history of performance that's similar to the ETF's benchmark index.

Evaluating an actively managed ETF is trickier. Costs still matter, of course, but just as with an actively managed mutual fund, a big piece of the puzzle is analyzing the ETF's potential for performance. Simply looking for high past returns isn't the right approach; it's possible the ETF has performed well by taking on a lot of risk. Ideally, you want to find an active manager with a history of adding value relative to the market, without taking on a lot of risk.

Complicating matters further is the fact that most actively managed ETFs don't have much of a track record so far; many are very new products. The goal in evaluating any actively managed strategy is to form a solid opinion of the manager's probability of performing well in the future. While past performance is no guarantee of future results, you can examine performance data to try to see how a manager is likely to perform in different future market environments. With no performance data at all for a new product, examining the potential for future performance is even harder. This is a good reason to take a "wait and see" approach with new products, even if the manager has delivered good performance with other products in the past.

You'll definitely want to consider the expenses of the active ETF compared to other active strategies such as mutual funds, as well as relative to index ETFs. If the ongoing expenses and trading costs are going to be higher with the actively managed ETF, make sure you have a good reason to believe that the ETF will deliver performance that's worth the extra cost in the future.

1. Source for all information in this section: Morningstar, as of April 30, 2012