By Ronald L. DeLegge - February 2, 2007
With each passing day the exchange-traded fund (ETF) industry moves further and further away from its original roots to traditional index investing.
Some have erroneously dubbed active management as the Holy Grail for ETFs.
But the facts say otherwise.
The Price of Innovation
The allure of active ETFs doesn't change eternal market truths.
Performance data still affirm that most active managers consistently underperform their benchmarks. Their failure is wide spread too, touching all asset classes from emerging market stocks to bonds. Active ETFs will not make beating the key market indexes any easier for money managers.
But wait, there's more.
Undoubtedly, active ETFs will introduce negative features such as higher expense ratios, higher portfolio turnover, and higher tax liabilities. In other words, the important financial advantages of ETFs would be cancelled.
Other nagging problems remain unresolved.
For example, can active ETFs guarantee the elimination of portfolio risks such as style drift, closet indexing and window dressing? Also, can they stop the never ending cycle of job hopping portfolio managers from disrupting the investment process by abandoning ship for greener pastures?
Then too, how do you make an active ETF thoroughly transparent without inviting evil market participants from frontrunning? And will the innovation of active ETFs make do-nothing fund boards more alert?
Unfortunately, active ETFs fail to eliminate some of the biggest threats facing investors.
Active ETFs already exist, they're called Closed-End Funds
If you want a sneak preview of how active ETFs would be, just take a look at the obscure world of closed-end funds.
It's a barren tundra where most funds persistently trade at premiums and discounts, but rarely at net asset value (NAV). In 2006, many closed-end funds surprised their shareholders with larger than normal tax liabilities. Contrast that with the current ETF industry, which has kept a lid on undesirable tax distributions.
Back to performance. Even with the help of leverage, the vast majority of closed-end fund managers fail to consistently beat their corresponding benchmarks.
In summary, the true cost of active management has proven to be much greater than the sky high expense ratios. The undistorted record of managed funds doesn't paint a very bright future for active ETFs.
Getting it Right
Regardless of what happens, the same old rules apply. Some things never change, nor should they.
Minimizing portfolio turnover, keeping expense ratios low, and maximizing tax efficiency will always matter. Over decades these factors contribute to the performance edge of index ETFs.
If active ETFs are the next big thing, maybe the future for ETFs isn't so bright after all.