Active ETFs are not ETFs

As the industry has grown, the range of ETPs has increased from simple index tracking ETFs to complex structured products and now so called ‘Active ETFs’ which allow investors to access the capabilities of active investment managers on ASX. These structures and the associated risks have deviated a long way from the passive ETF structures first listed in Canada and on ASX.

The term ‘ETF’ is often used incorrectly to describe an ETP that does not meet the strict regulatory requirements or provide the benefits to investors of a true ETF. Which is why it is important for investors to understand the key differences between ‘ETFs’ and ‘Active ETFs’.

To better understand the most common ETP structures, let’s start with the fundamentals.

ETF fundamentals

To qualify as an ETF, a fund must typically demonstrate the following key characteristics and benefits:

• It must be a registered managed investment scheme regulated by ASIC;
• The value of the fund must be linked to financial instruments approved by ASX which may include:
  • An underlying index;
  • securities, derivatives, bonds, or other financial products that are admitted to trading on ASX or recognised foreign exchanges; or
  • commodities or currencies;
• Units (like shares) in the fund are traded on ASX at live prices throughout the day;
• The fund provides full transparency to all its underlying holdings on a daily basis and in order to track the performance of the benchmark index as closely as possible must remain fully invested as much as possible therefore the fund holds negligible cash; and
• It is required by ASX to engage an independent market maker to execute buy and sell orders with investors to facilitate liquidity in the fund and which aims to ensure the trading price on ASX remains close to the fair value of the assets in the fund.

These are all key traits and important benefits of an ETF.

Plain vanilla ETFs

The first ETFs listed on ASX were plain vanilla index tracking funds. That is, passively managed funds whose investment strategy is to invest in companies in a traditional benchmark index in the same proportion as they are held in the index. The weightings of each company in such an index is based on its market capitalisation. For example: S&P/ASX 200.

Because plain vanilla ETFs are passive, they are also low cost. ETFs also have tax advantages compared to unlisted managed funds.

Smart beta ETFs

More recently, smart beta ETFs have entered the realm. The only difference between a smart beta ETF and a plain vanilla ETF is that a smart beta ETF does not track a traditional market capitalisation weighted benchmark index. Instead, smart beta ETFs track an index which is designed to provide a specific investment outcome by more strategically designed inclusion rules and by weighting the holdings differently than solely on the basis of a company’s market capitalisation. Smart beta ETFs offer the best of both passive and active investing because they utilise active investment strategies in a passive rules-based portfolio, retaining a low cost, relative to unlisted actively managed funds.

Some examples of smart beta index approaches are outlined below:

• Equal weight – all constituents are given an equal weighting regardless of their market capitalisation. Components of equal weight indices are often selected from a universe of stocks based on market capitalisation before being equally weighted. Equal weighting may be applied at the individual stock or sector level.
• Factor based – all securities based on factors such as quality, dividends, momentum, value, low size, low volatility or a combination of these. Portfolios may be weighted by factor (s) or by market capitalisation or a combination of these. Components of factor based indices are often selected from a universe of stocks based on market capitalisation before screening is applied.
• Capped weight – individual stocks cannot exceed a maximum percentage of the index. Components of capped weight indices are often selected from a universe of stocks based on market capitalisation before the capping is applied.
• A combination: some indices use a combination of smart beta strategies, such as a quality or value screen with a capped weighting.

Today, smart beta ETFs are the fastest growing segment of the ETF industry. Almost one in three ETFs listed on the ASX is now smart beta. It is likely this strong growth will continue as investors look to build wealth with low-cost products that provide more targeted investment outcomes.

Active ETFs

More recently, ‘Active ETFs’ have come to the fore. Active ETFs differ greatly from ETFs. Unlike ETFs, Active ETFs do not seek to track an index but rather they try to outperform an index. In addition, Active ETFs are not required to publish their full holdings at any time, so investors never know, at any time, exactly what stocks or how much cash is being held in the fund. This leads to potential concentration risks, inadequate strategic asset allocation and being charged fees on uninvested cash. Active ETF fees are also higher than ETFs due to the higher costs associated with operating an actively managed fund versus a passively managed index fund.

Research by S&P Dow Jones¹ has shown that the majority of Australian active funds in all categories have underperformed their respective benchmark indices over long-term horizons. This doesn’t bode well for the performance of Active ETFs. Launching an Active ETF is becoming a popular way for active managers to tap into the growing momentum of the ETP market. What’s key for investors is looking for the right active manager who has demonstrated consistently good performance over a number of years.

There is no doubt that the ETP industry is constantly developing and new innovations are coming to market. Importantly, investors need to understand that taking a passive approach via ETFs has a number of benefits over Active ETFs and can lead to long-term outperformance in a domain that was once ruled by actively managed funds.

_{¹ S&P Dow Jones SPIVA Australia Scorecard Year-end 2017}