We’re Only in the First Inning of Active ETFs

Investors have not been quick to embrace active ETFs since they were developed seven years ago. But some perspective is necessary.

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I’m often asked about the future of active exchange-traded funds. Given that we’re in baseball playoff season, I’ll put it in terms of said pastime: I see the entire ETF industry itself as being in the third inning of a nine-inning game. But active ETFs are just settling into the first inning. As is the case with many financial innovations, some figured that active ETFs would have an immediate and significant impact on the industry. So far, active ETF growth trends have been more in line with those of traditional, passive ETFs in their early years.

The first active ETF was launched in 2008. Only 30 active ETFs were launched between then and 2011, although during the next three years, firms unveiled roughly 100 new active ETFs, with 12 new entries so far this year. With about $21 billion invested in actively managed U.S. ETFs at present, these funds represent only a small fraction of the total amount invested in ETFs.

Let’s take a step back to gain some perspective. ETFs recently surpassed the $2 trillion level. It took time for investors to understand the advantages of passive ETFs, however, and for these vehicles to gain broad adoption. The requirement for active and passive ETFs to disclose their holdings on a daily basis creates concerns about front-running, the practice of investors trading on advance information.

Whereas these worries continue to limit the launches of certain active equity ETFs, it’s a different story for fixed income. Remember, because of the way the bond market works, it’s difficult for investors to front-run fixed-income strategies. Although individual investors can trade stocks electronically, along with institutional investors, the bond market remains an over-the-counter market lacking in liquidity and price transparency for all but the most liquid bonds.

Because individual investors cannot easily replicate an active fixed-income ETF, they tend to dominate the active space, especially those with high-profile active managers who have great name recognition. Note that the SPDR DoubleLine Total Return Tactical ETF, a collaboration between State Street Global Advisors and Jeffrey Gundlach and his DoubleLine Capital, recently surpassed $1 billion in assets under management since its launch in February.

Active ETFs face hurdles apart from the issue of transparency. Some, I think, will be cleared with time. Any active product generally needs a three-year track record to show its merit to an investor base. Furthermore, we could be entering a market in which investors begin to look more favorably on active funds, because correlations have decreased, volatility has returned, and dispersions may increase.

Cost is another factor with which we think investors will continue to wrestle. There has always been premium pricing within the active management sphere. And these active ETFs are generally more expensive than passive products. Active ETFs do tend, however, to be cheaper than active mutual funds. According to Morningstar data as of September 29, the average active equity mutual fund has a 1.58 percent net expense ratio (2.24 percent gross), compared with a 0.9 percent net expense ratio for the average active equity ETF (1.3 percent gross). The average active fixed-income mutual fund has a net expense ratio of 1.25 percent (3.86 percent gross) versus a 0.58 percent net expense ratio (0.76 percent gross) for the active ETF counterpart.

As was the case with passive ETFs, education will drive how investors evaluate and use active ETFs.

James Ross is global head of SPDR ETFs at State Street Global Advisors in Boston.

See State Street Global Advisors’ disclaimer.

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