Alex Illingworth, founder of Goshawk Asset Management and lead manager of the HANetf Global Balanced UCITS Fund, explains the workings and benefits of active ETFs.
Active exchange-traded funds look set to become a big part of portfolios in future years, as they can capture many of the best features of actively managed mutual funds, investment trusts and traditional, passive ETFs.
Historically, ETFs have tended to track an index and have enabled advisers to offer clients quick, easy and cheap passive access to a diversified portfolio of multiple investments. They are liquid and transparent.
Many advisers prefer the purely passive route today. However, given the extremely high levels of concentration in some indices – notably the S&P 500 and the MSCI All Country World Index – I believe there is an argument for even the passive afficionados to read on!
Active ETFs offer an interesting solution to the concentration problem. They may also appeal to clients looking for an opportunity to reduce volatility and/or outperform the market. There are some hybrid active ETFs, like those in the J.P. Morgan “enhanced ETF” range – which offers, for example, access to indices with exclusions. But ETFs that are managed in a fully active way – like traditional unit trusts or investments – are arguably only now beginning to be created to meet the needs of the generalist investor.
The first active ETF was launched in the US in the late 2000s. Research from HANetf shows that actively managed ETFs accounted for a record 25% of global ETF flows in the first half of this year. In Europe active ETFs saw $5.9 billion in inflows over the same period, bringing AUM to $45 billion.
To date, active ETFs have tended to invest thematically. They might focus, for example, on artificial intelligence or biotechnology. They could be considered specialist niche products. Now the wider investment community is recognising their attractions.
I have managed a unit trust and an investment trust. I have to confess that when the opportunity came to run an active ETF I did not fully recognise the benefits. It has been a useful learning curve. I am now convinced that they have a very big role to play in client portfolios and that advisers and paraplanners will be embracing them in the months to come. Look at the pros and cons of the various main fund structures below and you will see why.
Unit trust:
Pros
- Can usually be traded daily at NAV if underlying assets are liquid
- Wide array of options
Cons
- Less suited to illiquid assets like property
Investment trust:
Pros
- Can be traded when markets are open
- Closed-ended basis can provide an effective structure in which to hold illiquid assets
- Management fees tend to be cheaper than for unit trusts – perhaps because they have a board to represent the interests of investors
- Can gear to enhance returns in positive markets
Cons
- May sell at a substantial discount or premium to the NAV and will have a bid/offer spread, which may be higher for less traded trusts
- Attract a 50bps “stamp duty reserve tax” (SDRT) on purchase in addition to the bid/offer spread
Active ETF:
Pros
- Can be traded at NAV whenever markets are open
- Highly transparent – they disclose the entirety of their holdings daily, which can be particularly useful for advisers wishing to blend active ETFs within a broader portfolio and who need full disclosure of underlying holdings to optimise non-correlation and diversification
- Costs readily apparent
- Share creation and redemption process can be more cost-effective for providers and tax-efficient
- These cost benefits are potentially augmented by tax benefits for European investors – especially when investing in Irish-domiciled ETFs. Witholding taxes are 15% from US dividends for a fund domiciled in Ireland vs 30% if any fund (unit trust or investment trust) domiciled in the UK.
- No SDRT
- Tend to be cheaper than mutual funds
Cons
- Subject to a bid/offer spread, which may widen in times of stress – though less so for ETFs with liquid underlying assets
- Limited selection, but this is changing
An additional benefit of investment trusts and active ETFs is that many retail platforms charge for holding a unit trust in a pension or ISA – as much as 40bps a year – but some will cap the cost of holding company shares and ETFs, which can make overall costs very cheap for high-net-worth clients (or supported family) not on an adviser’s own platform.
Role of authorised participants
I am often asked how active ETFs avoid the issue of discounts and premiums – a problem that plagues investment trusts. This is due to the role of “authorised participants” (APs). When you trade your shares in an ETF, market makers help match you with a buyer and vice versa. If there is no counterparty then the APs step in to redeem or create shares.
These APs tend to be large banks like JPMorgan Chase, Morgan Stanley or Goldman Sachs. They make their profits on arbitrage – the bid/offer spread. Without this arbitrage mechanism, active ETFs would trade like investment trusts. There are no APs for investment trusts, which rely on their boards to issue or buy back shares.
In times of market stress there are concerns that APs might make spreads wider. This is yet to be tested but when the underlying security position sizes are small percentages of the fund and the portfolio is invested in large liquid equites which are easy to price, there should, in our opinion, be little concern.
Options
Our own active ETF, the HANetf Global Balanced UCITS Fund, aims to grow investors’ savings ahead of inflation over the long term. It will typically hold around 40 growth stocks, balanced with 15% in bonds (usually gilts) and with deep-value equities to reduce volatility. It has ongoing charges of 0.69%, and the bid/offer spread as I write is 32bps – less than for some global equity investment trusts.
At this point, in the tradition of guests on the BBC, I should say: “Other similar options are available.” Actually, I am not sure this is the case for such a one-stop solution at present – but I think it will be soon. We will not have the field to ourselves for too long.
I am always happy to talk to adviser businesses looking to understand this new area of the market. It is something we will all have to know about before long, and I am delighted to share my experiences and further insights.
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