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.
