Actively managed ETFs
An actively managed ETF is an ETF that does not follow an index. Instead, the fund's portfolio manager judgmentally decides what assets to buy and sell, within the general investing guidelines laid out by the ETF's Board of Directors, as specified in the ETF's prospectus. Some actively managed ETFs have broad guidelines that allow the portfolio manager to buy virtually anything, and some have guidelines that are more narrow and restrictive. You have to read the ETF's prospectus to understand exactly what the portfolio manager is allowed to do.
Benefits to an actively managed ETF
The debate between the merits of active portfolio management versus index investing is a long and complicated one. You can read our article active versus passive investing. So one of the biggest decisions an investor has to make is how much money to allocate to active investing strategies versus passive, or index, strategies.
For purposes of full disclosure, the owner of ETFAnalyst.com launched the website because he believes in index investing, so it is hard for this website to be too enthusiastic about actively managed ETFs.
Proponents of active portfolio management would probably argue that the biggest benefit to active management is that the portfolio manager has the freedom to research and explore investment opportunities, without being constrained by an index. They also think that it is a scary notion to be invested in all companies in an index, at all times, regardless of market conditions, and regardless of the fundamental qualities of those companies. If things get ugly, or difficult, proponents of actively managed funds want a portfolio manager to be at the helm, responding to market conditions as they happen.
Throughout history, Wall Street has glamorized certain fund managers like Peter Lynch or Warren Buffett, who successfully ran actively managed funds that significantly outperformed the stock market over long periods of time. Warren Buffett became one of the world's richest individuals because he is such a good stock picker.
But the truth is that it is very difficult for a fund manager, or any investor, for that matter, to outperform the stock market over long periods of time. S&P publishes an annual "SPIVA" study of the performance of actively managed mutual funds compared to their respective benchmarks. The evidence is overwhelming that it is very difficult for a portfolio manager to outperform an index, especially because of the higher fees that an actively managed fund must charge. So rather than try to predict which portfolio managers are in the small group of managers that truly can outperform the market, which is very difficult, "index investors" would rather just buy an ETF that tracks an index.
There are 15,000+ mutual funds in the United States, most of which are actively managed. If 5% of those funds are run by a portfolio manager who truly can outperform the market, that means there are 14,250 funds that will under perform the market over long periods of time. The odds are very low that an investor will be able to successfully pick a fund run by one of the superstar portfolio managers. And an investor never knows when that superstar portfolio manager will leave. No offense to the portfolio managers who are running actively managed ETFs, but what are the odds that those portfolio managers are in the 5% superstar group?
The positive thing about an actively managed ETF is the transparency of the ETF's holdings. Unlike a hedge fund or a mutual fund, with an actively managed ETF you can monitor every day what assets the ETF is holding. Currently, SEC regulations require an actively managed ETF to disclose their holdings on a daily basis (many portfolio managers are appealing to the SEC to rescind that rule, but with no luck yet). So that gives you more insight into the portfolio manager's strategy than would be possible with a hedge fund or mutual fund.
Risks associated with actively managed ETFs
#1 - They have short track records
As shown above, most actively managed ETFs are fairly new. Because of their limited history, they can be difficult to analyze. A newly launched actively managed ETF has a very difficult case to make to investors, because they can't really make any factual arguments to support why an investor should purchase the ETF, other than to essentially say: "buy our ETF, because we know what we are doing". A newly launched ETF that tracks an index can at least usually point to the history of the index, and make the case that the index has performed well in the past (or has exhibited some other positive trait, such as low volatility).
#2 - It can be difficult to classify actively managed ETFs
Many actively managed ETFs have investment objectives that are very broad and subjective. Many times this is intentional, because the portfolio manager wants the freedom to invest in a wide variety of investment vehicles. But this makes it difficult for an ETF investor to build a "precise" portfolio. One small reason for the success of ETFs is that ETFs allow an investor to build a precise portfolio - if you want 22% of your portfolio to be in low volatility stocks, you can do that with ETFs that track indexes. But you cannot do that with an actively managed ETF, because you are not quite sure what you are getting. It helps that you can go to the ETF's web page and lookup what they are currently holding, which clearly provides more transparency than an actively managed mutual fund.
#3 - It is really difficult for a portfolio manager to achieve alpha
Alpha is the fancy term that refers to the ability of a portfolio manager to judgmentally manage a portfolio so that it outperforms the stock market as a whole or another appropriate benchmark. As explained above, research has consistently found that it is really difficult for a a portfolio manager to achieve alpha. Even when a portfolio manager outperforms their benchmark, net of fees, over the short-term, it is very difficult to sustain that outperformance over the long run. The growth of the ETF industry has been driven by the belief that since portfolio managers cannot achieve alpha, it is better and cheaper to just follow an index. So the notion of an actively managed ETF is still somewhat controversial to true index investors.
#4 - Portfolio managers can stray from their primary investment style
One reason that ETFs have become so popular is that investors started to realize during the 1980's and 1990's that it was difficult to analyze the performance of a mutual fund because many portfolio managers would "secretly" change their investment style in an effort to increase returns. Or alternatively, many portfolio managers, especially those running large mutual funds, were secretly "closet indexers" who were not making investments that were that much different from their benchmark.
#5 - When they are successful, it can be hard to tell why
Investors started to realize during the 1980's that when a portfolio manager did manage to outperform their benchmark, often they did so by skewing their portfolio towards certain investment styles that were working (for example, growth stocks, or value stocks). It was therefore hard to know if the outperformance that was achieved was achieved because of the skill of the portfolio manager or because the growth stocks that they skewed towards outperformed other investment styles. The same thing is true of an actively managed ETF. It is often difficult to tell why they are either successful or unsuccessful.
#6 - Actively managed ETFs tend to have higher fees
Actively managed bond ETFs are more accepted
There are a higher percentage of actively managed fixed income ETFs than equity ETFs.
The perception in the market place is probably that it is more acceptable for a fixed income ETF to be actively managed than an equity ETF, but it is not entirely clear why. The SPIVA report shows essentially the same findings for both fixed income and equity funds, and actively managed bond funds typically have higher fees than an index fund. So it is not entirely clear why actively managed fixed income funds are not as heavily scrutinized as an actively managed equity fund.
The large number of actively managed bond ETFs is probably due to the nature of the bond markets and bond indexes. Unlike stocks, bonds are not usually actively traded. For one thing, many bond investors will purchase a bond and hold it to maturity. So some bond issues have very little trading activity. Yet many bond indexes include bonds that are not very liquid. This means that it can be substantially more difficult for a bond ETF to track a bond index, because it often is just not practical for a bond ETF to buy all of the bonds in a bond index.
Most bond ETF that seek to track an index choose to use "index sampling" as a way to track the index. In fact, virtually all bond ETFs use index sampling. Index sampling means that the bond ETF does not try to purchase every bond in the index, but rather the bond ETF judgmentally decides to purchase a sample of the bonds in the index. Hopefully, the sample bonds will accurately track the performance of the entire bond index.
Because of the popularity of "index sampling", is there really that much of a difference between a bond ETF that is tracking an index using index sampling, and an actively managed bond ETF? It is often hard to say. In either case, a portfolio manager is judgmentally picking which bonds to purchase.
Perhaps the biggest difference between an actively managed bond ETF and an index bond ETF is that an investor probably has more assurance that the index bond ETF will not stray from their primary investment objective. An index ETF that is seeking to track a corporate bond index generally must use 80% or 90% of their assets to purchase the corporate bonds in the index. An actively managed bond ETF that normally purchases corporate bonds may have an investment policy that allows the ETF to purchase other types of bonds, besides corporate bonds, at the discretion of the portfolio manager. In either case, you have to read the ETF's prospectus to understand each ETF's exact investment policy.
Conclusion
We would never tell you to not purchase an actively managed ETF -- there are no absolutes in investing. But it would take a lot for us to ever recommend an actively managed ETF. Perhaps if there was an actively managed ETF that was clearly pursuing a unique strategy that was not available through an index ETF.
It's a guessing game as to which active portfolio managers have enough skill to achieve 'alpha' - the ability to outperform the market. Are any of the 590 actively managed ETFs managed by the next Warren Buffett? It is difficult to say, especially since most of the actively managed ETFs are fairly new. We don't really want to invest money based on examining a portfolio manager's resume or work history. They are all really talented people who are probably smarter than we are. But the odds are too stacked up against them.
Our attitude with any ETF is that there are so many choices available that an investor should not buy an ETF unless there is a compelling positive case for the ETF. Otherwise, move on until you find an ETF that does have a compelling positive case. That explains why we are reluctant to endorse a newly launched actively managed ETF.