Mutual Funds Walking, Not Running, Toward ETFs
Yes, with great anticipation and fanfare both Pimco and Schwab have proclaimed their intention to enter the ETF space. And both will likely bring with them actively managed strategies. But, given the staggering capital flows out of traditional, actively managed mutual funds and correspondingly massive flows to index-based ETFs, where’s the stampede of active mutual fund managers to the ETF structure?
We can still count on one hand the number of actively managed ETFs, comprising all of $21.5 million in assets and 0.0048% of total market ETF assets (4/14, consisting of five Powershares active ETFs of which two are formulaic and represent one-half of the assets; total ETF market assets as of Feb 09, source ICI). Hardly a relevant feature on the ETF landscape at present.
Why the slow rollout pace for actively managed ETFs? One need look no further than the “what’s in it for me?” question.
What changes for the active manager that “goes ETF”?
The most important operational change is that fund holdings must be reported daily, rather than quarterly, sixty days in arrears. In the active manager’s “what’s in it for me?” ledger this is a definitive negative. While the ETF format doesn’t hang the active manager’s strategy in public view, it does – on a daily basis – display the fund’s holdings. Daily reporting of ETF holdings also removes any opportunity to hide aggressive active manager behavior that might otherwise forever remain out of public view in a traditional mutual fund format. The long reporting cycle for the traditional mutual fund enables position “clean-up” activities or “window dressing” to the detriment of shareholders.
What changes for the investor drinking the active-manager kool-aid via an ETF wrapper?
Holdings transparency – going from holdings data that is three-to-five months stale to daily visibility. This is important for any risk manager – enabling a “trust but verify” doctrine.
Improved tax efficiency – ETF creation / redemption activity is generally classified as non-taxable, in-kind exchanges – generally significantly stripping funds of the internally-generated capital gains commonly experienced in traditional mutual funds.
What doesn’t necessarily change: An active mutual fund manager doesn’t necessarily shed a cent of overhead when adopting an ETF structure. And it’s not in any active manager’s m.o. to surrender fees simply to compete with passively-managed index-based ETFs – charging, on average, one-fifth as much as actively managed mutual funds (average for US equity ETFs, Morgan Stanley, “ETF Overview and Strategies”, 11/19/08, p16).
What else doesn’t change: Active managers consistently under-perform their self-selected index benchmarks. Active managers outperforming their index benchmark in any given year reside squarely in the minority, with those managing the feat two or three years running fewer yet. And when both fees and the element of luck are stripped away, less than one percent of active mutual fund managers outperform their index benchmark in any given year. Taking fees to zero, improves the active manager’s chances of outperforming the fund’s index benchmark to nearly ten percent when the element of statistically random luck is removed (Wermers, et al, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”, 5/08; also in related NY Times article, “The Prescient are Few”, Mark Hulbert, 7/13/08)
While index-based ETFs have achieved critical mass and clearly have gone mainstream, actively-managed ETFs have not yet “arrived” and, at least in the near term, active managers will continue to struggle with the “what’s in it for me” question as indexed-based ETFs continue their forward march.