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The rise and rise of Active ETFs

ETF Watch - Aug 09, 2018

Some time ago we took a look at Exchange Traded Managed Funds or “Active ETFs”. At that time only a handful existed, although it was clear this approach was becoming more popular. We predicted then that we’d see plenty more of these products list, and fast forward 2 years and the number of Active ETFs has doubled, with 6 new listings this year alone. We take a look below at why Active ETFs are taking off in popularity.

What are active ETFs

Active ETFs are a sort of cross between a traditional ETF and a Listed Investment Company (LIC). They share the same tax structures as an ETF, being a trust structure. This structure means that all income earnings must be paid out as distributions. This is one of the key differences to a LIC which can retain earnings and thus smooth out their distributions.

The biggest difference in the two structures is the way they raise capital. LICs, being listed companies raise their capital the same way as most companies who list on the share market, with a reasonably short window for investors to invest in the Initial Public Offering (IPO).  The IPO is generally marketed by a number of brokers, and at the end of the offer period, the books close. Once listed, investors simply buy and sell existing shares on the secondary market (in our case the ASX). Occasionally LICs will raise more capital, but this tends to follow a similar process to the IPO. This means there is a finite supply of shares in a LIC and is why LICs can trade at discounts and premiums to their NAV, with supply and demand of the shares not necessarily aligning to the underlying NAV.

ETFs on the other hand have a theoretical unlimited number of shares that can be issued, with ETFs having a market maker sitting behind their product. The market maker offers sellers the opportunity to buy their units (if there are no buyers on the secondary market) or to make new units to sell (if there are no sellers on the secondary market). This means that they always trade at or very close to their underlying Net Asset Value.

Active ETFs generally manage this market making activity themselves. As the underlying holdings are a key to the fund manager’s intellectual property, they retain this knowledge and complete the market making. For passive ETFs, generally a group of specialised market makers create the market and make a profit by collecting a small bid/ask spread.

If you got lost in the above somewhat technical explanation, essentially Active ETFs are actively managed, they always trade at (or close to) their underlying NAV and must pay out all income as distributions.

What active ETFs are out there?

We class 25 of the 178 ETFs out there as Actively Managed. These have a combined market capitalisation of $2.5b, representing a reasonably small proportion (6%) of the total size of the ETF market of around $40b. However, with 11% of total flows to ETFs in the 2018 Financial year going to Active ETFs, it is a growing sub-segment in the ETF space.

10 of these ETFs have been launched in the last year, with the segment now boasting some of the biggest fund managers in Australia through Magellan and Platinum Asset Management. It also includes boutique managers like Montgomery Investment Management, Switzer Asset Management and InvestSmart. Traditional ETF providers Betashares and Vanguard have even dipped their toe in the water, with Betashares partnering with some large active asset managers (AMP & Legg Mason) as well as launching their own Active Hybrid Shares ETF. Vanguard have recently launched a couple of their popular Quantitative strategies as ETFs.

Why are Fund Managers Launching Active ETFs?

The traditional path for fund managers to distribute their product to retail clients has been through Australia’s army of 20,000 odd Financial Advisers. Fund Managers pitch a case for an Investment Platform or “Wrap” product to include their product on the platform. They then pitch a case to be included on a Financial Adviser Licensee’s Approved Product List. Once they have this, financial advisers then have access to these products to adviser their clients invest. Prior to the Future of Financial Advice (FoFA) reforms in 2013, the fund managers could pay Advice Licensees a ‘shelf space’ fee to be included on an approved product list. This has now been banned due to the obvious conflicts of interest that may arise from this.

The above makes sense for the advised client, and is still the most popular way for fund managers to see their products distributed. However, it ignores the increasingly prevalent self directed investor. There’s now over 600,000 Self Managed Super Funds in Australia, with many having the members make their own investing decisions, as well as the hundreds of thousands of investors using the power of the internet to research, compare products and make their own investing decisions. The investment platforms or “Wraps” discussed above really aren’t designed for or well marketed to these investors.

Many fund managers have always had direct investment options, but with clunky signup processes generally involving paper forms and verified IDs, large minimum investment amounts and clunky processes to redeem funds (more paper forms), they have never had large appeal to retail investors.

Enter the Active ETF. With the simplicity of access through a single share trade, they are as easy for investors to buy as a share in BHP or CBA, but provide access to professional fund managers that previously may have been difficult for self directed investors to access. Additionally, it provides a distribution channel for small fund managers who may not have the size and scale to access investment platforms and Advice Licensee product lists.

We asked Ron Hodge, CEO of InvestSMART why they chose launch their recently listed Australian Equity Income Fund (INIF) as an Active ETF.

“InvestSMART’s goal in launching INIF was to give investors access to a strongly performing portfolio in a simple, cost-effective way. Therefore we felt the Active ETF structure was the most appropriate way to achieve this.

Active ETFs offer an exchange traded open ended fund structure with unlimited daily inflows and outflows which trade very closely to their underlying NAV making them popular with self-directed investors. Unlike Listed Investment Companies (LICs )and Listed Investment Trusts (LITs), which are close ended funds. ETFs also offer transparency as they are required to regularly publish the entire contents of their portfolio.”

Ron's view on the ETF structure’s place in the investing world:

“…the media attention on fund manager fees has helped to put the spotlight on the affect of fees on investment outcomes. Therefore we believe the ETF market in Australia will continue to gather pace.

Much of the growth in ETFs has come from self-directed investors and self-managed super funds (SMSFs), who value the ability to build diversified portfolios with the liquidity and transparency they are looking for.”

It’s not just the traditional active managers looking at active ETFs. ETF provider Betashares recently decided to launch their Hybrid Security ETF (HBRD) as an Active rather than passive or Smart Beta ETF after recognising it is a sector that best warrants an active rather than passive approach. The kings of index investing, Vanguard even recently rolled out active ETFs VMIN and VVLU, which use Quantiative techniques to make the active investing decisions.

What does the future have in store?

We’ve got no doubt we have only seen the tip of the iceberg for Active ETFs. The ETF structure provides the perfect vehicle for retail investors to access the expertise of professional fund managers, active and passive alike. We see a time a few years from now where the majority of managed funds have an ETF offering alongside their more traditional offerings, and see a point where hundreds of Active ETFs are available. More choice for investors can only be a good thing and we’ll continue to report on the growth in this space.

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