Actively managed exchange-traded funds (ETFs) can be confusing. Many people assume that an ETF inherently means a fund that passively follows an index. That is, after all, what the vast majority of them do. And more to the point, that’s how they’re usually marketed: Since most investment managers can’t consistently beat the market, why not simply “buy the market?” And the fact that there is no active manager means that a passive ETF can be offered cheaply.
But there’s nothing inherent in the term “exchange-traded fund” that stipulates passive investing. It just has to trade on an exchange. You can, in fact, structure a fund as an ETF and have an active manager picking the stocks or bonds.
The resulting confusion over actively managed ETFs may well be why these investments never really caught fire (There are fewer than 30 after being introduced two years ago.) The biggest stumbling block has to do with costs. If it’s so cheap to passively follow an index, why introduce a manager into that equation?
And for the most part, that’s a valid point. But there are times when a traditional ETF (one that passively follows an index) is hard to implement. They’re relatively easy to understand in theory, but it’s not always easy to track an index in reality. Or more specifically, it’s not always easy to buy the exact same securities that make up an index.
In large-cap stocks, it’s not a problem. And ETF can easily buy the stocks in, say, the S&P 500, then create a fund and let it ride.
But when it comes to some segments of the fixed income market, it’s not quite as simple. An ETF can face the same challenges in buying some obscure high-yield or emerging market bond that a regular investor would encounter: the bonds aren’t always available to buy, said Tim Clift, senior vice president and chief investment officer of FundQuest.
According to data that Clift provided, the SPDR Barclays high-yield ETF [JNK] underperformed its high-yield benchmark by 1.13% this year, as of Sept. 30, with a tracking error of 0.54%. And last year was more extreme. It underperformed by 13% with a tracking error of 2.84%.
He gave a couple other examples when fixed-income ETFs were just unable to match the indexes they were supposed to be tracking. The SPDR Barclays International Treasury Bond ETF [BWX] underperformed its benchmark by 2% with a tracking error of 3.18%, as of Sept. 30. And the SPDR Barclays Long Term Bond ETF [LWC] underperformed by 1.78% year-to-date with a tracking error of .58%.
So when you talk to clients about their fixed-income investments, if they are drawn to the idea of passive investing, bear in mind that it’s not always going to be so easy to really track those indexes.
There are a couple other challenges facing this market so far. One major disadvantage for fund managers in actively managed ETFs is daily disclosure of their holdings. The transparency of an ETF is one of the attractions for investors. They know where their money is going every day. But active managers are not used to that level of specificity with their investments. Many will have reservations that a motivated investor could simply duplicate the fund’s holdings on their own.
Another thing holding back the growth of actively managed ETFs is the lack of a long track record. Unlike mutual funds, actively managed ETFs debuted in 2008 so they don’t have multiple years of performance.