Update on Active ETF’s

By: ispeculatornew
Date posted: 04.05.2010 (5:00 am) | Write a Comment  (2 Comments)

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While ETF’s have been around for a few years now and have already gained a lot of market share, almost all of them are still passive ETF’s. They are passive in the sense that they track an index, usually a known one such as the S&P500, but also very often less known ones. An ETF like UNG (Natural Gas) tracks an index, a custom one that tracks futures contracts on a pre-determined schedule. They are custom but you do know exactly what you are buying when you have a position on these.

By contrast, Active ETF’s are asked to beat indexes the same way a hedge fund manager or many mutual fund managers must do so. Of course, they all have a strategy that is generally disclosed. You will not know in advance what the fund will buy but you will know what is trying to accomplish. For example, buying a “short bias” ETF would make sense in many circumstances. But don’t expect the fund to beat indexes in an up year.

So how are they doing?

In terms of performance, it is still very early to tell. Some are doing better than passive funds, some are not. In any case, it’s very difficult to judge these funds on a few months or even a year. Like any other fund, they will need to build a history in order to get more investors involved.

As far as the number of funds, there are more opening each month but I’m still a bit surprised to see there are not more funds out there. My best guess would be that since ETF’s took off so quickly, issuers put all their energy into the easier ones, those that can be promoted in a clear way because they track a precise index. The active ones require a lot more time and energy and will likely not gain much interest until they have a track record of a few years.

How to compare their performance?

I would say that in general, each fund needs a different benchmark depending on how it was defined. A fund that is long only and invests in Nasdaq stocks should probably be compared to the Nasdaq index or or to QQQQ. But others will be a lot more difficult to judge.

Powershares has a few funds that are more easily comparable and they have been fairly strong so far and outperforming their passive equivalents. The question of course if it will keep up. My guess would be it will be similar to mutual funds and hedge funds; most will fail to deliver but the best ones will generate big returns for their investors.

Fees involved

One of the major concerns for active ETF’s is the fees structure. Like other ETF’s they usually have a flat percentage fee. That is fairly easy to evaluate. The other thing to look at is the presence of “incentive fees”. These fees can add up very quickly because they are generally a portion (generally 20%) of the performance above a specific benchmark. These can add up very quickly and should at least be considered. Not to say that you should not invest though. One of the largest hedge funds, SAC Capital, charges 50% of their return above benchmark. Crazy? You bet! But when a fund returns over 20% annually, investors are generally willing to go on the ride.

Conclusion

While I am personally on the sidelines right now, I am far from ruling out active ETF’s and could consider an investment in the next few months. How about you? Have you tried one out? Considering one?

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2 Comments

  1. Comment by Neil Murphy — April 5, 2010 @ 7:15 am

    Thanks for the excellent article. With the entrance of active management into the ETF structure, is anything really different?

    The first issue going against active management is always costs. Costs have always been a drag on actively managed portfolios and have been a significant factor in their underperformance against passive investments. In order to market their services in the ETF world, active managers are showing lower cost than with mutual funds. However, they are adding on a performance fee. This fee could result in significant increases to the cost. The simplistic argument of course is that no one will mind paying a performance fee for performance. But it neglects the fact that should the manager underperform, you do not get a refund of your money. Therefore, the manager has an incentive to take on much higher risk chasing the short term performance payout. This could hurt you very badly in the long run.

    Secondly, in my viewpoint, one of the largest factors that is so frequently overlooked, is the tax factor. Active managers trade very frequently and have high portfolio turnover. This triggers annual tax bills. With passive funds, these tax bills are in large part avoided as capital gains are not being crystallized since there if very little turnover in the portfolio. This factor alone could cause a significant underperformance and is not mentioned in any literature for actively managed funds.

    Next, higher trading results in higher trading costs. Trading costs are not quoted in either of the active or passive manager’s numbers. Passive management has very low trading cost, active management very high costs. This is another eroding and invisible factor.

    Finally, when creating a new ETF, the savvy active managers will seek out and select a story that can be pitched. Which managers have done well over the last five years? Which trading strategies? They will build ETFs around these and pitch them to the market. But as we have learned over the years in the mutual fund world, last year’s rising star is often next year’s falling star. Be very cautious of the hype, it will be like the wild, wild west for a while with active managers entering the ETF world.

    If you are seeking active management to augment your passive portfolio, I would suggest a couple of alternatives. If you have under $500,000 to invest, consider buying some mutual funds directly from the manager. There are a few good ones out there with low MERs and great track records. Mawer Canadian Diversified Investment and Leith Wheeler Balanced seem to be two good examples of balanced funds that have outperformed over a very long period. There are others. Search GlobeFund for balanced funds with low MERs.

    If you have over $500,000 then you should consider dealing with an Investment Counsellor for the actively managed portion of your portfolio. Investment Counsellors deal exclusively with the wealthy and charge a fee for their service. Just like in mutual funds, there are good ones and there are bad ones. We help our clients find the good ones. With Investment Counsellors, you will find a manager with a track record, you will get a custom portfolio, and you will have transparency into your portfolio. Oh, and you will get service, do not underestimate good service.

    Until actively managed ETFs can develop a track record, it makes sense to deal with active managers and structures with a proven track record. Keep the ETFs for passive investing for the time being.

    Neil Murphy
    Weigh House Investor Services

  2. […] It’s too early to tell but the Intelligent Speculator checked in on how actively-managed ETFs were performing against the benchmarks. […]

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