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Active management and ETFs: a powerful combination

ETFs are structured to provide liquid, cost-effective and transparent access to global markets. These attributes have lent themselves perfectly to index tracking funds, allowing investors to add low cost beta exposure to portfolios, easily and efficiently, whenever they choose. 

Passive ETFs have been hugely popular, driving the strong growth in the US ETF market that we’ve seen over the past two decades. More recently, ETFs have experienced similarly impressive growth in Europe, with assets under management rising at a compound annual growth rate of 19% in the five years to the end of 2016, according to Morningstar. 

PwC, in its Annual Global ETF Survey 2015, predicted that the European ETF market could reach $1.5trn (€860bn) by 2021.

The dawn of the active ETF

While passive ETFs continue to dominate flows, fund providers are increasingly realising that the ETF wrapper is also an ideal home for actively managed strategies. Active ETFs are one of the factors that will drive further ETF growth, providing investors with the opportunity to earn alpha on their investments while still gaining all the benefits that they expect from the ETF vehicle. 

One of the key advantages of active ETFs is that they allow investors to target specific outcomes. For example, an active equity ETF can provide access to excess returns above a chosen index, driven by fundamental stock selection. 

aum rebased since the inception of first etf in the us and europe

Because the weighting methodology in active strategies is at the discretion of the portfolio manager (within certain tracking error constraints), some active ETFs can partly mitigate some of the limitations that are inherent in market-cap indices. Active fixed income ETFs, for example, have the ability to assess the creditworthiness of individual issuers and deviate from the weighting methodology of traditional fixed income benchmarks, which give larger weightings to issuers with higher outstanding debts. 

Active strategies can also be used to gain exposure to certain investment criteria, such as securities with strong environmental, social and governance characteristics.  

Another advantage of active ETFs is their ability to rebalance portfolios outside of the systematic rebalancing dates used in passive indices. This flexibility may be beneficial in reacting to unexpected market events. 

Moving up a gear

The trend towards active strategies is helping to take ETF growth to the next level. ETFGI reports that active ETFs and ETPs (exchange-traded products) reached $95.9bn in global assets in July 2018, up from $15.3bn in December 2012. This represents a 39% annual growth rate over this period (see ETFGI Active ETF and ETP Insights, July 2018).

As demand for active strategies grows and more active ETFs are launched, it’s important for investors to have a full understanding of how they can be employed in portfolios, and the due diligence and trading questions that they should be asking their ETF providers. 

Active ETF due diligence: pay attention at the engine level 

Before investing in an active ETF, investors need to conduct due diligence at the ETF wrapper level, in much the same way as they would with a passive ETF. 

However, because the benchmark is only a reference for active ETFs, the range of possible outcomes and performance deviations from traditional benchmarks will be much greater than with passive ETFs. Active ETFs will therefore require more upfront and ongoing due diligence at the “investment engine” level than market cap-weighted index strategies. 

Understand the ETF investment engine

In an active ETF, stock selection, investment allocations and risk management will be based on a portfolio manager’s investment philosophy, conviction and skill. It’s therefore vital that investors ensure the active strategy is based on a proven, repeatable process that aligns with their risk tolerance and overall investment objectives. 

Questions to ask include: 

  • What is the starting universe of eligible securities?
  • How are securities selected and weightings assigned in the portfolio?
  • What are the portfolio’s diversification and liquidity constraints?
  • What biases or exposures can be expected as a result of portfolio construction?
  • How experienced is the portfolio management team?
  • Does the strategy have a verifiable track record? 

Know your ETF provider

As with passive investments, when evaluating potential active ETF investments, investors should consider the character and capabilities of the ETF provider. Investors should choose to invest with a provider they value, and that has a proven history of delivering investment expertise and insights. 

Investors particularly need to ensure the ETF provider is able to give them the level of client support they need. Does the provider have a multi-language client service desk? Does the provider have a capital markets desk that can support with trading questions, and dedicated websites that provide critical fund information? How well aware and aligned is the provider to the regulatory changes impacting the industry?

Investors should also ask how much access the ETF provider is willing to give to its investment teams to discuss strategies in detail.

total investment cost

Evaluate the total cost of ownership

As with passive ETFs, the full cost of investing needs to be carefully evaluated. Low fees are attractive, but the total expense ratio (TER) is just one component of the overall investment cost of an ETF.

As well as the TER, investors need to evaluate other costs incurred for holding an ETF, which include such factors as transaction costs related to portfolio rebalancing, and any costs associated with securities lending. Investors will also need to account for the cost of purchasing and exiting the fund. These charges include brokerage fees, and creation and redemption costs.

Together, the cost of holding and the cost of trading will provide investors with a view of the total cost of ownership of an ETF. 

Assess the implications of ETF structure

While the costs and risks associated with physical and synthetic (swap-based) index replication are less relevant for active ETF investors, structural implications are still important to consider. For example, active ETFs may participate in security lending schemes to offset costs, similar to many physical replication passive ETFs. 

Although UCITS collateral requirements mitigate counterparty risks somewhat, active ETF investors should assess and monitor the performance of ETF providers and make sure they understand all the credit exposures that an ETF strategy may have. 

Active ETF trading: what makes a good active ETF?

As with passive ETFs, a good active ETF will be backed by a dedicated capital markets team with a strong technology platform and strong relationships with a diversified set of authorised participants (APs). 

The ETF provider must be able to demonstrate that it can provide APs with all the information they need to deliver efficient pricing of the ETF at all times, while utilising both primary and secondary markets to boost liquidity.

Focus on the ETF’s underlying securities

Some strategies will not be appropriate for the ETF wrapper, so it’s important to ensure that the ETF strategy provides ample trading liquidity. 

First and foremost, a good active ETF strategy needs to maintain exposure to liquid and tradeable underlying securities, which will allow the cost of creating and redeeming shares to be low, and the ability to provide intra-day pricing to be high. 

  • Assess the starting universe 

Just like passive strategies, active ETF portfolios are constructed based on a starting universe of underlying securities – taken either from the starting point of a reference benchmark, or from the universe covered by the relevant portfolio management or analyst team.  

Active ETFs will therefore share similar characteristics to the starting universe. An active ETF with a starting universe of US equities, for example, will be more liquid and cheaper to trade than an active ETF with a starting universe of emerging market bonds. 

  • Analyse portfolio construction

While the liquidity of the starting universe is the main driver of an active ETF’s underlying liquidity, investors will also need to look at the fund’s portfolio construction to get a true view of its liquidity profile. 

This means analysing the investment criteria used to select securities, the risk management tools that the strategy uses, any tracking error considerations that are in place, and any individual security restrictions or other portfolio constraints that will influence the makeup of the portfolio.

  • Focus on trading expertise

While many equity indices rebalance on a quarterly basis, active strategies often adjust portfolios on a monthly basis. 

However, active ETF strategies also have the flexibility to trade outside of their normal rebalancing period, which means portfolio managers can buy or sell securities to reflect a change in market view at any time.

To facilitate intra-day portfolio rebalancing, ETF providers can reissue the daily portfolio composition files (PCFs) that APs use to create or redeem shares throughout the day. This allows the ETF provider to maintain full pricing transparency in real time as the underlying portfolio changes are made.

Investors in active ETFs should therefore ensure that the ETF provider has the requisite trading expertise and capital markets resources, as well as the technology support, to deliver these extra trading requirements while also providing best execution and price transparency to investors.  

Focus on secondary market liquidity

As with passive ETFs, secondary market liquidity is just as important for the efficient pricing of active ETFs. 

If an ETF suffers a redemption, or receives inflows, it may not need to trade its underlying securities if an AP or market maker is able instead to find a willing buyer or seller for the ETF’s shares in the secondary market. APs may not therefore need to create or redeem shares – and trigger trading in the underlying securities – every time they receive a buy or sell order for an ETF.

It’s therefore important to assess the ETF’s ability to access secondary market liquidity. However, the level of visible “on exchange” liquidity may not provide the whole picture. Consolidated trading reports, which show the level of hidden over-the-counter (OTC) trading as well as exchange-based trading, can help give a better view of an ETF’s secondary markets access. 

the etf ecosystem

Using active ETFs in an investment portfolio: strategic building blocks

ETFs provide a powerful portfolio construction tool for institutional investors. Today, advanced strategies such as smart beta fixed income, multi-factor strategic beta, ultra-short income and liquid alternatives are allowing investors to build ETF portfolios with a level of sophistication and diversification that they couldn’t have envisaged even just five or 10 years ago.

More efficient asset allocation

The buy-and-hold nature of active ETF strategies (where turnover of underlying assets is relatively low) makes them particularly well suited to helping investors build out the strategic core of their portfolios. 

At the same time, an active strategy can be used to add alpha to a portfolio with core passive holdings.

For example, if an asset allocator wants to add exposure to a less liquid category, such as emerging market debt, using an ETF within an emerging market sleeve can help them to increase or decrease their exposure without buying or selling individual bonds or managers. Other examples include using active ETFs to add alpha to a plain vanilla portfolio, or using an actively managed growth-style ETF to reduce a portfolio’s value bias at low relatively cost.

Ultimately, active ETFs offer investors access to long-term alpha potential, while benefiting from the attributes of the ETF wrapper.

Bryon Lake, head of international ETFs, JP Morgan Asset Management