Three Active ETF Gamechangers

by on April 8, 2010 | ETFs Mentioned:

The rise of the ETF industry has been truly remarkable in almost every way. A surge in product offerings has democratized asset classes and investment strategies previously available only to institutions and the super-rich. ETFs have been embraced as an efficient means of accessing everything from copper to Treasuries. And while the industry remains very top-heavy, more and more funds are receiving a warm reception from the market and seeing assets surge.

But one area has been a bit of a disappointment. Actively managed ETFs, which some expected to pose an immediate and formidable threat to traditional mutual funds, have been slow to gain traction. When they launched amidst great hype (some of it from ETFdb), huge success seemed like the most likely outcome. But few actively-managed equity funds have seen assets climb above $5 million, and only a couple have topped $20 million (bond funds, particularly those from PIMCO, have done much better).

Catching On

Recently, active ETFs have shown some indications of catching on with investors, as cash inflows have reflected an increased comfort level with disclosure requirements and other nuances once seen as obstacles. Moreover, the number of firms filing for exemptive relief to offer active ETFs has surged, and the list includes more than a couple big names in the investment business (see Handicapping the Active ETF Race). As these firms trickle in (a process that will likely be delayed by the SEC’s investigation into the use of derivatives by ETFs and mutual funds), their reputations and existing customer bases will no doubt give active ETFs a shot in the arm.

So a slow trickle of cash into active ETFs seems likely. But there are a few potential developments that could accelerate growth in this space significantly. Below, we discuss three potential “gamechangers” that could set off an active ETF growth spurt.

1. Superstar Manager

No disrespect to Hotchkis and Wiley (a subadvisor to GVT) or Jerome Schneider (the portfolio manager for MINT), but the roster of current active ETF managers isn’t exactly full of household names. Many of the largest and most popular mutual funds are those run by living legends of the investment business, such as PIMCO’s Bill Gross or Legg Mason’s Bill Miller. If an active ETF run by one of these superstar managers (or others held in similar esteem) were to hit the market, investors would be lining up down the block and around the corner to get a piece of the action.

Of course there are some obvious reasons why mutual fund firms may be hesitant to pursue this strategy; it could/would cannibalize the more lucrative actively-managed business. And outperformance from the ETF version could anger existing investors. An ETF version of the Legg Mason Value Trust or PIMCO Total Return Fund is unlikely (at least in the near term), but could change the ETF landscape if introduced.

2. The Three Year Mark

Some investors believe the widespread adoption of active ETFs is only a matter of time. And they might be right. Some active ETFs have delivered impressive alpha since their launch, but haven’t received the amount of attention one might expect. The PowerShares Active U.S. Real Estate Fund (PSR) is a good example. Since its inception in November 2008, PSR has obliterated its benchmark (at the end of 2009, the performance gap since exception was more than 30%). But PSR is less than three years old, and as such isn’t yet eligible for a Morningstar star rating. The universes of a lot of advisors and institutions are limited by this measure of quality (for example, some asset managers are only allowed to invest in four-star or five-star funds). Once the first generation of active ETFs hits the three year milestone, they will be accessible to a lot more investors. By that point, there will be a better (though still relatively short) track record that will allow investors to make more informed decisions about the manager’s ability to generate alpha.

The first active ETFs turn three years old in April 2011 (PSR reaches this point a few months later), so we’ll be able to gauge the impact of this milestone shortly.

3. Mutual Fund Conversion

There really isn’t an easy way around the lack of a track record issue facing most active ETFs. Or is there? The folks at Grail are reportedly close to convincing a few “well-known investment management firms with good track records” to convert existing mutual funds to actively-managed ETFs. This idea is interesting for a few reasons. It would allow these funds to skip through the process of finding seed capital and building up sufficient trading volumes, a process that can drag on for months or years in many cases. If an existing mutual fund converted to an ETF, it could potentially have a huge leg up (in the form of an existing investors base) on an otherwise similar fund started from scratch.

A hypothetical mutual fund-turned-ETF would also immediately have a track record that investors could examine when considering an allocation to the fund (although we’re admittedly not certain how Morningstar and other ratings providers would handle this situation). This would address one of the major hurdles currently facing active ETFs.

Some of these gamechangers are long shots, while others are inevitable. One thing is certain though; the active ETF industry is still very early in its development, and come interesting times lie ahead.

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Disclosure: No positions at time of writing.