Our Perspective on the Barron’s Article on “Going Active”
Perspective on “Going Active” from Barron’s
After reading the past weekend’s edition of Barron’s that included a special report on active ETFs, some additional insights came to mind but we should first point out two immediate clarifications:
1. Derivatives are no longer an issue for both index ETFs and active ETFs. The SEC has completed their review of derivatives in ETF exemptive requests and is now allowing their use. The SEC even went as far to issue a no action letter for firms such as PIMCO, who initially obtained ETF exemptive relief without derivatives, to now be able to include them.
2. The listing of the top 10 active ETFs omitted the AdvisorShares Peritus High Yield ETF (HYLD) (although later corrected in the story’s online version).
That being said, we feel other areas covered in the story require a different perspective.
The story suggests that established firms are not interested in “cheaper” iterations of existing strategies, but hasn’t PIMCO proved you don’t have to charge a lower management fee? Strategies will be priced based on the value that a manager feels they provide. It is also important to remember that some aspects of an active ETF are more operationally cost efficient and certainly much more tax efficient—these two elements can provide a lower overall total cost (though keep in mind, spreads and commissions increase any ETF’s overall total costs).
The article mentions many “industry observers” suggest 2013 is the year for active ETFs. Who are these industry observers, and do they know anything about the distribution process of active strategies? Unless you are similar to PIMCO, the reality is it will take some time. We believe over time as more strategies demonstrate their ability to perform, assets will follow good performance.
In our opinion, the panel was spot on regarding ETF managed portfolio strategies. Only looking at the $60+ billion already tracked, overshadows that many financial advisors don’t promote their own managed portfolio strategies but still use ETFs to implement their active strategies. We believe the biggest misconception on the growth of index ETFs is about passive management. Index ETFs are the most widely traded securities, with considerably more financial advisors using these products to implement their own active strategies that likely represent well over half of all index ETF assets. The growth of index ETFs is more about the empowerment of advisors having decided to take the active management into their own hands – not a statement in support of buy and hold passive investing. Keep in mind just as this works for beta baskets, this empowerment will work with implementing alpha baskets into these managed strategies as well.
Closing a Successful Fund to New Investors
In the story, Vanguard’s Joel Dickson raises an interesting concern if an active ETF became so successful, the manager could feel the need to close the ETF to new investors. He seems to indicate that the potential resulting premium in the share price of a closed ETF would be detrimental, but we are not so sure. It’s a peculiar point because when a sponsor closes a fund, it is done to protect the existing shareholders. Based on his premise that the active ETF is successful—assuming that is from an asset perspective—and was to close and begins to trade at a premium, it’s literally the best of both worlds. As the premium will likely further ensure no new shareholders would buy the ETF, any of the existing shareholders that want to exit can then sell at a premium too (assuming the ETF is trading at a premium as Dickson suggests). Or if for some reason investors feel it’s worth the premium, new shareholders can pay it because they have a choice.
After a section that describes the arbitrage process for active ETFs—which is a bit unusual since this process is applicable to all types of ETFs—attempting to connect to transparency, Barron’s Brendan Conway writes “if the entire market knows what a manager is buying or selling in real time, it’s a bit like showing your hand in poker.” It’s a funny line, but just not true. The portfolio is not disclosed in real time, it is disclosed the day after the manager makes a change. It’s not like showing your hand in poker – it’s like playing your hand then showing your cards, and then privately playing the next hand until you are done for that day. This is an important function for ETFs and an important benefit. Have you seen one piece of research that says a manager loses alpha with transparency? We have certainly seen plenty of managers who can’t provide alpha without transparency.
Nobody actually demonstrated how front running would be an issue in an active ETF. Just because one can see what was in the portfolio yesterday doesn’t mean anyone knows what the manager is going to do tomorrow. And every time this is mentioned for a transparent active ETF, why isn’t it discussed more often for an index-based strategy—assuming the index is transparent and can be consistently front run on each rebalance. Kudos to Cambria’s Meb Faber and PIMCO’s Vineer Bhansali for calling transparency a non-issue.
Eaton Vance’s Stephen Clarke provided a surprising explanation how an exchanged traded managed fund (ETMF) functions. First, our primary concern is the lack of transparency, believing that is a step backward. But we were most surprised to hear that while their proposed product would list on an exchange, it won’t actually trade during the day. Clarke tries to explain that an ETMF order will be “filled,” but the actual price won’t be known, instead only disclosing the mark up (for a purchase) or mark down (for a sale). Hypothetically speaking, how would investors react if selling such a fund, locking-in a trade during market hours at a few pennies discount to NAV, but won’t know the price until after 4pm when the fund strikes an NAV, while the market plunges in that elapsed time?
We bet mutual fund companies would sign up for this even without being exchange listed. Can you imagine how fund companies, which today will take your order any time during the day and get you out at NAV without a mark up or mark down, would look at these products? It would present an avenue to make more money by just being available to take an order that won’t be executed until later.
It’s an unusual model in that Clarke seems to suggest the market maker doesn’t have hedging costs. But if the market maker is expected to hold inventory to fill orders, then they have daily exposure to changes in the strategy, while masking the holdings only increases their risk and thus likely increases the mark up or mark down on the trading. After the first time a market maker takes a hit on the lack of transparency and the hedging, look for an even bigger impact to those mark ups and mark downs (or maybe better to refer to them as premiums and discounts).
Lastly, the prominent mutual fund (Fairholme Fund) cited by Morningstar’s Ben Johnson is a poor example of the type of strategy that wouldn’t be a good fit for the liquidity of an ETF. In fact, the mentioned fund is the perfect example of the inefficiency of the mutual fund structure. In the Fairholme example, a lot of hot money comes in which is more wear and tear on the portfolio manager to put the cash to work. There is a cost to do that: spreads and settlement costs that impact both the new investors and your long-time shareholders. Then something happens: the fund falls out of favor, all the hot money is flying out, the PM is now selling what he can to meet redemption requests with those costs again impacting the departing shareholders, but also being born by the long-term shareholders. In reality, it is the long-term shareholders that will suffer the most by the tax inefficiency of the capital gain generating transactions.
If this same scenario happened in an ETF, the hot money would bear their own costs, paying their own spreads and commissions, and baskets of securities would be delivered to the fund. And if the reverse scenario occurred and the hot money left, the departing shareholders would pay their own costs of commissions and spreads, and securities would be delivered out in kind creating a future tax benefit for the long-term shareholders. This exemplifies the greatness of an ETF structure, where each shareholder pays for the cost of their own activity, and long-term holders can benefit from short-term holders who help create better tax efficiency and smaller spreads. And, it’s one class—everyone is treated equally, and the retail shareholders can benefit from the economies of scale by investing alongside institutional investors.
Barron’s is a great publication with terrific journalists such as Brendan Conway, but unfortunately some essential points were missed.