Are active etfs the future? paul rickard thinks so

When global funds management giants such as Fidelity or Vanguard start launching active ETFs, that is, actively managed exchange traded funds, it is time to sit up and take note? Is this the next generation of managed investment products that might signal the death of traditional managed funds or listed investment companies?
 

What are active ETFs?

Unlike traditional ETFs that slavishly follow an index, with an active ETF, the manager is actively determining the composition of the investment portfolio. In all other respects, they are the same as traditional ETFs.

Traditional ETFs, such as the iShares S&P/ASX 200 ETF (ASX Code IOZ), track an index and are passively managed. You are “guaranteed” to receive the return of the index, less a small management fee. So for IOZ, if the S&P/ASX 200 goes up by 5%, your return will be around 4.8%. If the S&P/ASX 200 drops by 5%, your loss will be around 5.2%. With an active ETF, your return will depend on the assets the ETF is investing in and of course on the skills and expertise of the manager.

Active ETFs are also quoted and traded on the ASX, employ a unit trust structure, are open-ended funds, publish an end of day net tangible asset value (NTA), will usually publish a ‘real-time’ indicative intra-day NTA, have market makers and disclose their portfolio composition on a regular basis.
 

How many active ETFs are there?

There are now more than 20 active ETFs trading on the ASX, covering most of the major asset classes including Australian shares, international shares, fixed interest, infrastructure and property. Managers include Magellan, Montgomery, Platinum, Legg Mason, Vanguard, WCM and Switzer. The latest addition is Fidelity, which has launched the Fidelity Global Emerging Markets Fund. It will trade under the ticker FEMX.
 

Active Exchange Traded Funds

How do active ETFs stack up to unlisted managed funds?

Compared to unlisted managed funds, active ETFs stack up very favourably. Both employ an active management style, use a trust structure and are open ended, meaning that they grow or contract in size depending on investor demand. Sometimes, unlisted managed funds are closed to new investors.

It is the listing and quotation on the ASX that makes the difference. This means that via their broker’s website, on-line trading portal or app, investors can at all times see the price of the units and readily buy or sell units. Settlement occurs via the ASX’s CHESS system on the normal T+2 (2 working day) basis. Provided the market maker(s) appointed by the manager are doing a good job, trades should be occurring very close to the NTA of the fund.

For all intents, the ETF looks, trades and settles just like a share.

Additionally, the manager will publish on its website an “indicative” NTA or iNAV. This is a “real time” price, usually updated every 60 seconds, which takes into account market or currency movements on the day (in other words, it adjusts last night’s closing NTA for movements that have occurred during that day).

Redemption of units in unlisted funds usually takes longer than 2 working days, can be frozen at the Manager’s discretion and can include a buy/sell spread. There is, however, no brokerage to pay. Also, there is no guarantee that buyers and sellers of units in an active ETF will get a “fair” price, but the publication of an iNAV means that they can readily check before transacting.
 

How do active ETFs stack up to LICs?

Listed investment companies are of course companies (not trusts). Arguably, this gives LICs two advantages over ETFs. Firstly, the declaration of a dividend is a discretionary action by the directors. Potentially, a LIC can “smooth” the payment of its dividends. On the other hand, an ETF utilises a trust structure which in most cases means that it is required to distribute the income as it receives it, notwithstanding that it may be lumpy.

Perhaps more importantly, LICs have a finite pool of investible funds. Many say that this makes it a lot easier for the investment manager because they don’t have to worry about investing inflows of funds or keep cash on hand to cater for redemptions.

But the big problem for LICs is the trading on the ASX and purchases or sales occurring a long way from “fair value”. Because there is no market maker to make bids or offers, and often a real lack of transparency about the actual NTA, LICs can trade at sizeable premiums or discounts to their NTA. Thin markets with few participants can exacerbate the situation. Unbelievable as it may seem, investors pay $1.10 for a “paper” asset (share) really worth $1.00 (buy at a premium) or sell a share for 90c when if the assets of the LIC were sold, it would be worth a $1.00 (sell at a discount).

As the following graph from the ASX shows, this problem is endemic. Of the 111 listed investment companies, 75% were trading at a discount, with over one third trading at a discount of more than 10% to their NTA.  Only 28 were trading at a premium to their NTA on 31 October. 
 

LICs – Premium or Discount to NTA as at 31 October

Transparency, governance and reporting is another major issue with LICs. Under ASX rules, LICs have 14 days after the close of the month to publish their NTA. While many LICs choose to report on a weekly basis, others report just once a month and then leave it to the due date. Potentially, the last reported NTA can be up to six weeks’ out of date!
 

What could go wrong with an active ETF?

Apart from poor performance, as could happen to any actively managed investment including a LIC, an active ETF could also be affected if an outflow of funds started to impact on the investment manager’s ability to manage the investments or required the forced liquidation of assets. As open ended funds, they can be vulnerable to fund flow surges (in or out) or ongoing withdrawals.

Normally, this wouldn’t be an issue but could become a problem if the fund lost “critical mass”. Also, active ETFs are dependent on having strong market makers (often the Fund itself) to provide ongoing liquidity to unitholders.
 

The future

If the investment opportunity is a finite size, illiquid in nature or is of such a long term nature that investors won’t require liquidity for several  years, the listed investment company structure can make sense. However, the case for exchange traded funds, whether active or passive, is compelling due to the improvement in liquidity, transparency and ease of dealing and settlement. Further, the perennial challenge of premium/discount for LICs shows no signs of abating and as more investors understand this shortcoming, they will give the flick to the promoters of new LICs,

Active ETFs are the future.