Innovation in the exchange traded fund (ETF) structure1 has led to the increased adoption of active management in ETFs. Active ETFs provide a low cost solution for investors along with access to high caliber active manager's expertise. In order to understand the significant progress made in the ETF market, it is important to look at the history of why and how ETFs have evolved.
As with most developments in the financial industry, ETFs were created to solve an investor need. In the early 1990s, ETFs were originally developed as short-term trading vehicles, allowing for quick intraday exposure to major markets with one trade. It wasn't until the next decade that ETFs became a preferred long-term solution to efficiently track passive indexes that covered asset classes around the world.
The next key phase for ETFs was the development of "smart beta," or enhanced indexing. Smart beta is defined as the use of alternative index construction rules to traditional market capitalization based indexes. Furthermore, smart beta is a systematic, rules-based approach with a set rebalancing schedule that attempts to isolate a theme while taking human emotion out of investing. Once a smart beta index is created, the ETF manager simply tries to replicate the index with low tracking error.2 In the early 2000s, the first series of U.S. smart beta ETFs were launched with the debut of growth and value factor tilts to major indexes. It wasn’t until after the 2008 global financial crisis that smart beta ETFs' popularity translated in to increased asset flows. Currently, many investors target smart-beta products as a buy and hold investment to gain exposure to a certain factor or alternative investment theme, directly competing with traditional active managers. Recent entrants to the U.S. ETF smart beta space include some of the largest asset managers in the world.
More Flexible Future for ETFs
Since their inception, ETFs have often been described as a disruptive technology – and that holds true with the most recent emergence of actively managed ETFs. Active management in the ETF wrapper ultimately gives the ETF manager flexibility. Active portfolio management allows for all of the quantitative benefits of smart beta but with the additional control of a "pilot behind the wheel" to adapt quicker to a rapidly changing investment environment. Actively managed ETFs allow for a different investor experience than passively following a smart beta index.
Specifically, there is a qualitative element involved that allows for human intervention around rebalancing and security selection that is not present in a strictly rules-based methodology. Not being confined to a quarterly or semi-annual rebalance schedule for example can give an active manager a potential edge.
Market Events Call for Mindful Rebalancing
Just this year, the surprising Brexit vote resulted in a global sell-off and heightened volatility causing markets to trade down significantly on Friday, June 24, 2016 – which happened to fall on the same day as the annual reconstitution of the Russell Indexes. When indexes undergo reconstitution, they add, remove, and re-rank stocks based on current market capitalization. If faced with future market events such as June 24, 2016, actively managed products would have the option to adjust their trading strategy while smart beta funds would have to follow their set rebalancing schedule. Additionally, an active manager can exclude certain securities from the investment process on the fly if a company's characteristics suddenly change. For example, if news hits that a company is being targeted for merger or acquisition it may be deemed not worth the risk of remaining in the investment universe and can be removed instantly.
ETFs Evolving Along with Investors' Needs
The biggest hurdle for actively managed ETFs has always been the transparency that is required on a daily basis, which more asset managers are becoming comfortable with for certain strategies and asset classes. Currently, the U.S. Securities and Exchange Commission (SEC) has not granted exemptive relief to any active nontransparent ETF solutions. Asset managers are becoming more vehicle agnostic, developing a strategy that fulfills investor needs and then implementing that discipline in the most efficient wrapper. Only time will tell what iteration of the ETF structure will come next. It will be interesting to see what the next innovative step will be.
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1 An exchange traded fund, or ETF, is a marketable security that tracks an index, commodity, bonds, or a basket of assets like an index fund. ETFs trade like common stock on a stock exchange and experience price fluctuations throughout the day as they are bought and sold.
2 The term "tracking error" refers to the difference between a portfolio’s returns and the benchmark or index it intends to replicate or outperform.
ETFs trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value.
Unlike typical exchange-traded funds, there are no indexes that the Active ETF attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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