The ETF market has been one of the greatest investment management success stories of recent decades. Historically, most ETFs have deployed passive strategies, enabling institutional and retail investors to track indices, for instance. A key part of their appeal has been low costs (relative to active mutual funds) and intra-day liquidity, which enables investors to hedge existing investments or take directional views on a market.
For the ETF industry however, the product has never been solely about passive strategies. Rather ETFs have been seen simply as a wrapper and a way to distribute a product: provided there is sufficient liquidity and an underlying asset that can be priced on an intra-day basis, the wrapper is suitable. Armed with this belief, there is now growing industry interest in active ETFs and a small, though growing, number of listed active ETFs in the US.
It is important to differentiate between transparent active ETFs, where the underlying assets are disclosed on a daily basis, and non-transparent active ETFs. Transparency is important to market-makers because it enables them to value the ETF on intra-day basis in order to provide accurate pricing.
Some active ETFs provide transparency (although given that underlying asset information is from the previous day, market-makers still run a risk should the ETF manager have changed the portfolio markedly). However, many active managers have been unwilling to share asset information on a daily basis because they regard stock picks, for instance, as intellectual property, and believe the sharing of asset information could undermine performance.
Over the past year, the SEC has given the go-ahead for non-transparent active ETFs, accommodating some managers’ reluctance to divulge asset information – hence the newfound interest in active ETFs. A variety of patented models have emerged in the US that provide limited or delayed visibility of the assets in an ETF: a handful of so-called non-transparent active ETFs have so far launched using these mechanisms.
Why Europe is Different
Inevitably, given that the European ETF market tends to follow developments in the US – albeit with a significant lag – questions are now being asked about whether such non-transparent active ETFs will come to the European market.
There are a number of reasons why the fairly limited enthusiasm shown thus far for non-transparent active ETFs in the US could be more limited still in Europe.
- There is a fundamental difference in the drivers of ETF market in the US and Europe. When ETFs were first devised in the US, one of their greatest selling points was low costs. In part, these derived from index-tracking strategies that do not require highly remunerated fund managers to execute. However, ETF managers also took advantage of a beneficial loophole: when money is brought into funds on the basis of a security-for-security swap rather than in the form of cash there is no capital gains tax payable. This gave ETFs a major advantage over mutual funds, which could not exploit the loophole.
In contrast, in Europe mutual funds do not pay capital gains tax and therefore there is no advantage for the ETF product in terms of tax.
- The fee benefits of ETFs are less readily apparent for active products than for passives. Moreover, the difference in fees between ETFs and mutual funds is less dramatic than in the past. The UK’s Retail Distribution Review in 2013 has largely debunked the myth that ETFs are inherently cheaper than mutual funds. Now that trailer fees are no longer paid to mutual fund distributors, overall costs for investors have come down. Indeed, some providers now offer index-tracking mutual funds at a lower cost than similar ETF products.
- Traditionally access has been a key driver for ETF take-up. Part of the access benefit comes from ETFs being available to any investor via a regular broker account. However, a large part of the attraction of ETFs is the ability to trade in and out of markets on an intra-day basis.
In both the US and Europe, it is unclear whether there is retail demand for an active product that facilitates intra-day liquidity. Traditionally, active investment has been about longer-term investment whereas passive investment can have multiple purposes, including hedging, trading or managing excess cash.
It is true that for younger investors, real-time access and immediate pricing are a key requirement for investment products. Many younger investors find the concept of buying a mutual fund at an uncertain price with a significant lag in placing an order and receiving the product to be incomprehensible. Nevertheless, it remains to be seen whether such investors would rather trade active products on an intra-day basis (with all the complexity they entail) rather than passive products, where it is it is easier to take a straightforward view on the market or use a product for hedging, for instance.
Don’t Bet Against Industry Creativity
While there are smart beta ETFs listed in Europe (which have active components such as ESG, risk or volatility) these are more akin to passive than active products.
Traditionally, regulators in Europe have been reluctant to provide guidance about product concepts (in contrast to the US). Instead, regulators in Europe usually require the filing of a prospectus, the details of which are then the subject of discussion and amendment. However, given the novelty of active ETFs in the European market it would be useful to have a clear position to allow managers to structure non-transparent active ETFs and understand in advance what principles should apply. It is especially important that there is a single clear European position from the European Securities and Markets Authority (ESMA) and that a series of individual country positions do not emerge.
The lack of regulatory certainty about whether active ETFs would receive regulatory approval in Europe is no doubt contributing to the limited interest we currently see from fund managers to investigate their potential. As importantly, European retail investors (which in any case represent a smaller component of the ETF market in Europe than the US) appear content with the status quo, where active strategies are largely confined to mutual fund products. Neither is there an obvious clamouring for active ETFs among institutional investors: index-tracking products may meet their need for hedging or managing excess cash more efficiently. Nevertheless, given the creativity of the ETF industry since its inception, it would be foolish to bet against the prospects of non-transparent active ETFs in Europe. They could well be added to the roster of investor tools available in the region – and sooner than one might think.
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