Active ETFs are a great Aussie invention

Share

Active Exchange Traded Funds (ETFs) are a great Aussie invention for investors as well as a global-leading product. They combine the benefits of active fund management (the ‘active’ part) with the convenience of being traded like a share on the stock market (the ‘ETF’ part).

Australia is one of only two countries (Canada is the other) in the world that allow Active ETFs in the way we define it. In the US, they are limited to ‘smart beta’ funds as so-called Active ETFs in the US must provide daily disclosure of their portfolio and active managers are unwilling to disclose their stock selections daily. Authorities in Australia gave approval to Magellan initially for quarterly portfolio disclosure and that was the start of the Australian Active ETF market.

Some misunderstandings of Active ETFs

Much has been written about ETF risks and definitions. For example, Roger Montgomery wrote in a note to clients, “Is this another diversification trap”, in November 2018 that

“investors who think ETFs offer safety through diversification are no more protected than those who invested in mortgage-backed collateralised debt obligations (CDOs) before the global financial crisis.”

I realise this is meant to refer to the pitfalls of market cap index investing and its concentration in certain sectors but it fuels the confusion that ETFs themselves are bad by associating ETFs overwhelmingly with passive investing.

Arian Neiron from Van Eck (an ETF provider) wrote in July 2018 that, “Active ETFs are not ETFs” because they don’t track an index, don’t publish their holdings and have higher fees than passive index ETFs. This implies that passive index ETFs somehow have the ‘right’ to be called ETFs but Active ETFs don’t. The same logic would suggest that a passive managed fund is not a managed fund as the vast majority of managed funds are active funds. Neither is true.

ETFs have benefits for investors

Neither Montgomery nor Van Eck’s arguments go to the heart of what an Active ETF is, including:

Simple: I’m not sure when you last applied to invest directly in a managed fund but I’m sure after the first 20 pages of form filling you were left wondering why it’s so hard. Try doing that across multiple managed funds and it’s enough to head to the pub to spend your hard-earned savings. Any ETF, active or passive, are bought and sold like a share on the ASX. Open a brokerage account once. Trade as many ETFs as you like at the click of a mouse without any more forms.

Accessible: A typical managed fund has a minimum investment size of anywhere between $5,000 and $20,000. ETFs have no minimums and can thus be bought in smaller amounts.

Low transaction cost: Investing in ETFs requires the payment of a brokerage fee as with buying or selling an ASX share. These costs usually depend on the size of the transaction but trading online starts at $10 to $20. This includes the ASX as your ‘platform’ to settle and report a trade. Those costs are good compared to managed fund platform costs that are between 0.2% – 0.4%. Fund manager fees for Active ETFs are broadly similar to equivalent strategies in an unlisted managed fund. Passive ETFs typically have lower fees than Active ETFs, much the same way that passive unlisted managed funds have lower fees than active unlisted managed funds.

Liquid: One of the most common misunderstandings about ETFs is that they are only as liquid as the number of ETF units that trade on the ASX. ETFs do trade like shares and the liquidity of a share is indicated by its average daily value traded. Unlike shares, ETFs hold a basket of securities (such as shares) and the liquidity of the ETF is determined by the liquidity of the underlying basket of securities. The ASX rules only allow liquid securities as investments in Active ETFs and thus the liquidity of an Active ETF is many multiples larger than the ‘on-screen’ ASX value traded in the ETF. If all the investors in an ETF wanted to sell out of the ETF, the ETF issuer could sell the (liquid) basket of underlying securities to return the cash to the investors. Two identical strategies in the form of an ETF and a managed fund would have the same liquidity. The ETF would have the added ‘liquidity’ benefit to an investor of the ability to buy and sell the ETF (and switch into other ETFs) intraday. This liquidity is not available in unlisted funds.

Transparent: ETFs are bought and sold at net asset value or NAV (less a bid/offer spread much like managed funds). There are no discounts or premiums to consider, which can exist with closed-end funds such as Listed Investment Companies (LICs). ETF prices are quoted ‘live’ on the ASX during trading hours and issuers of Active ETFs publish an indicative NAV or iNAV that closely approximates the actual portfolio NAV during the day. Unlisted funds by comparison typically offer end of day NAV for subscriptions and redemptions. An investment made in the morning must wait for a price to buy the fund at the end of the day. Active ETFs are required to disclose their full portfolio holdings. Yes, for some Active ETFs, this is only provided quarterly, but it’s still a higher level of disclosure than most unlisted managed funds.

The rise of Active ETFs

The ETF industry in Australia is still relatively small. ASX-listed ETF assets under management (AUM) at end December 2018 was about $40 billion, roughly the same size as the LIC market. This is not a bad effort given the ETF market is much younger.

Of that, Active ETFs are only about $3.5 billion and are the new kid on the block. By contrast, the Australian retail managed fund industry AUM is about $600 billion, most of which is in active funds.

ETFs therefore make up less than 7% of the managed fund industry in Australia. By contrast, in the US, the ETF industry has US$3.5 trillion of AUM and is about 20% of the size of the mutual fund (managed fund) industry. The penetration of ETFs in Australia is destined to catch up with that of the US. Active ETFs, coming off a low base, will show even stronger growth.

Active ETFs are a great Australian invention and the regulator and stock exchange should be applauded for showing global leadership.

 

Chris Meyer is Director of Listed Products at Pinnacle Investment Management which includes global equities manager Antipodes Partners that recently launched an active global equities ETF. This article is for general information only and does not constitute personal financial advice nor consider the needs of any individual.

Share
Print Friendly, PDF & Email

, , ,

One Response to Active ETFs are a great Aussie invention

  1. p thornhill February 7, 2019 at 11:15 PM #

    I have appended below an abstract from a paper written by 2 economics professors in the US and would welcome your comments.

    “Abstract
    Exchange-traded fund (ETF) trading volumes have increased over the last
    decade, and so have unsettled ETF trades at the clearing corporation. ETF fails-todeliver
    (FTDs) are large and persistent despite SEC rules that require timely
    close-out. We document positive relationships between net daily ETF settlement
    failures and daily short sale volume, stock borrow costs, put option open interest,
    and quarterly index options expiration (so-called “triple witching” dates). These
    findings are consistent with the hypothesis that market makers fail to deliver to
    avoid paying borrowing costs associated with their short sales. We also document
    a positive relationship between short sale demand and changes to ETF shares
    outstanding. We then document that positive changes in aggregate ETF FTDs
    Granger-cause higher market index volatility. This is because market makers are
    required to buy or borrow common stock to close-out ETF FTD positions on or
    before trade date plus six days (“T+6”).”

Leave a Comment:

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Register for our free weekly newsletter

New registrations receive free copies of our special investment ebooks.