SMSFundamentals: ETFs Get Active

SMSFundamentals | Apr 16 2019

SMSFundamentals is an ongoing feature series dedicated to providing SMSF trustees with valuable news, investment ideas and services, in line with SMSF requirements and obligations.

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ETFs Get Active

A change of heart from the US SEC may open the door for rapid growth of actively managed ETFs both in the US and Australia.

-Few active EFTs listed to date
-SEC backs down on transparency requirements
-Interest in active ETFs expected to grow

By Greg Peel

Investment funds can initially be divided into two categories – passive and active.

A passive fund seeks only to provide an equivalent investment return to a particular benchmark, such as the ASX200, by holding a portfolio replicating that benchmark. The fund manager cares not whether the index goes up or down as it is the investor’s decision to be passive.

Other passive funds may create a portfolio that does not specifically replicate a benchmark but invests in a particular theme, such as “high yield stocks”. Once the portfolio is established it’s a case of “set and forget”. The fund manager may choose the stocks but it is again the investor who decides if the portfolio is worthy of investment.

By contrast, an active fund seeks to provide superior returns to a particular benchmark, such as the ASX200, by creating a portfolio of stocks the fund manager believes can outperform the benchmark that is not fixed in its composition. The fund manager can buy and sell and rejig positions within that portfolio as it sees fit without reference to the investor.

In this case the investor is not so much investing in a portfolio but in a portfolio manager. Clearly a fund’s track record becomes its major selling point. In a non-listed fund the fund manager is not obliged to inform the investor of portfolio changes beyond mandated periodic reporting..

It is at that point the investor typically learns the “price” of that fund, reflecting its return. By contrast, exchange-traded funds, listed on the stock exchange, are priced in real time by the market. ETF sponsors are obliged to provide a bid and offer price if no other exists at any time.

Active fund managers do not publish their portfolio selections other than periodically given this is their “intellectual property”. If selections were publically available then anyone could follow the fund manager without actually investing with the fund manager. This is also the case in Australia with active ETFs. It would be a bit pointless for an ETF sponsor to share its proprietary selections with the world.

Which is why, until recently, active ETFs were few and far between in the biggest ETF market of them all, the US. The US Securities & Exchange Commission required active ETFs to disclose their portfolios on a daily basis, thereby disclosing their buy/sell choices on any day, for fear a “black box” ETF could not be priced by the market, thus a comparison to the sponsor’s bid/offer price could not be made.

This requirement kept most active managers out of the burgeoning US ETF market.

Yet in a rare case of the tail wagging the dog, the SEC this month provided conditional approval allowing active ETFs to trade without being obliged to disclose portfolio selections on a daily basis, thus catching up with Australia.

Not that the Australian market is teeming with active ETFs either. But Antipodes Partners, an associate of Pinnacle Investment Management in the US, has recently launched an active ETF. In reference to the SEC decision, Pinnacle’s director of listed products, Chris Meyer, suggested:

The move could potentially spur many more fund managers to offer more active ETFs while allowing them to protect their intellectual property of the securities they own by not revealing their portfolio changes to market on a daily basis.

The decision is considered a win for active stock pickers who do not want to reveal their holdings for fear front runners and others may seek to capitalise on predicting their next move.”

Active ETFs in the US will still be obliged to publically disclose their portfolio holdings quarterly, as is the case in Australia.

As the active ETF market grows in the US, increased education on what active ETFs are and the benefits they offer for investors should help stimulate interest in, and adoption of active ETFs in Australia,” Meyer suggests. “That bodes well for the industry’s growth”.

In the US, ETFs represent in excess of 20% of the broader mutual fund industry. The US accounts for almost 70% of the global US$4.8trn ETF market, indicating how important a change like this could be for the adoption of active ETFs globally in the view of Antipodes Partners.

By comparison in Australia, the ETF market is at about 7% of the retail managed fund industry and was valued around US$30bn as at end 2018.

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