Bozena Pomponio, The Daily Record Newswire
Actively managed Exchange Traded Funds are the latest product in the industry being offered to investors. ETF’s have become a significant investment vehicle in the last 13 years. The first ETF was first introduced by State Street 20 years ago after a fund sponsor received U.S. Securities and Exchange Commission exemptive relief from different provisions of the Investment Company Act of 1940 (the “Act”) that would not otherwise allow the ETF structure.
Currently it is a $1,453 billion industry, up from $71 billion in 2000. ETFs are investment companies that are registered under the Act as open-end funds or unit investment trusts. ETFs sell their shares at Net Asset Value (NAV). Traditional ETFs are managed to mirror the holdings and performance of particular index.
ETFs are attractive because they exhibit low costs, transparency and tax efficiency. They track underlying indexes and they don’t change frequently making them relatively cheap in comparison with mutual funds.
There are reasons why investors prefer ETFs over mutual funds. They have the ability to trade intraday at current market prices, unlike mutual funds, which use the end of the day prices. Another reason is the expense ratio, which is much lower for ETFs. Finally, the history has showed that indexing provides more consistent returns for most investors when comparing to open-end funds.
Unlike traditional ETFs which are index-based, actively managed ETFs are exchange traded funds that have managers who actively manage the portfolio. These funds do not seek to follow the performance of any particular market index. The managers of these funds pick securities consistent with the ETF’s investment objectives and policies without referencing composition of any index.
Fund managers are reluctant to reveal what they’re buying for fear speculators will front-run their trades, a tactic that can artificially boost the prices of their best ideas. Investors will be left to put their faith in the managers’ stock-picking skills. These new funds will be starting from scratch, and they will have to work to build trust and garner assets.
Investors trade ETF shares throughout the day at market prices in the secondary markets. Actively managed ETFs are more like mutual funds. The goal of actively managed funds is to try to take the best attributes of ETFs and mutual funds and combine them.
In approving these first orders, the SEC has come down squarely on the side of daily disclosure of portfolio holdings. Each application represents that the ETF would be fully transparent, similar to index-based ETFs. Consequently, on each day, prior to the commencement of trading on an exchange, each such actively managed ETF will be required to disclose its portfolio holdings that will form the basis for its calculation of NAV at the close of trading on that day.
However, because there are managers involved, the fee will be higher for actively managed ETFs, which will be passed on to the investor. Also, active trading tends to increase costs and therefore lower returns. In addition, the managers of ETFs could decide to buy or sell a stock on a given day, which makes much harder to track the fund’s value and holdings.
Active ETFs may or may not change their holdings each day, depending on what the markets are doing. Whether they do or not, whatever holdings there are will be disclosed each evening to preserve transparency, which was a condition of the SEC’s granting of the relief.
Actively managed ETFs can be also compared to closed-end funds. Closed-end funds have similar characteristics to actively managed ETFs. Both contain baskets of securities, trade intraday on the open market, and are professionally managed. However, some important distinctions exist that may make investing in closed-end funds more attractive than actively managed ETFs.
Closed-end funds issue a fixed number of shares that are traded in the open market and traded at a premium or discount to the NAV. When closed-end funds trade at a substantial discount to NAV they have a tendency to outperform ETFs in various market conditions. Unlike closed-end fund shares, the market specialists and institutions tend to keep ETF shares as close to the NAVs as possible.
The closed-end fund’s discount provides the investor with a cushion against future declines in the fund’s NAV. In addition, closed-end funds have been around for decades where actively managed ETFs are brand new, have no track record and will have to work to build trust.
ETF’s have gained in popularity over the last 20 years, however, closed-end funds have been around since 1929. Before being enticed by the advantages of actively managed ETFs over open-end mutual funds, take a look at their older cousin — the closed-end fund.
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Bozena Pomponio is an analyst/portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees.
