Active exchange-traded funds (ETFs) have emerged in recent years as a way for traditional fund houses to take market share from the growing passive players.
But for those firms who want to turn their killer equity strategies into an ETF, they are encountering a big problem: transparency. ETFs are required to disclose all of their holdings daily.
Around 72% of active ETF launches are bond funds and there is a reason for that. The world of fixed income is a lot murkier, with less price transparency.
The head of one firm which recently entered the UK market told Wealth Manager they want to launch their active equity ETF from Australia into the UK as part of their expansion, but said it is ‘impossible’ while the current transparency rules are in place.
They said: ‘It’s something we’re keen to do but until the regulation changes, what’s the point? It defeats the purpose if you’re forced to give away the recipe for the secret sauce.
‘I think they need to look at the regulation there, because I doubt we’re alone in [wanting to launch an active equity ETF in the UK].’
Nick King, head of ETFs at Fidelity International, told Wealth Manager last November that the firm was exploring ways to launch active ETF strategies in the UK, but added that portfolio disclosure was the key challenge.
Last month Fidelity finally entered this space, but chose Australia to launch its first product. Other firms have been favouring countries like Australia for active ETF launches as they are allowed to report their holdings on a quarterly basis, unlike in the US, UK and other countries in Europe.
Following a discussion paper on ETFs, the Central Bank of Ireland recognised the issue of transparency on active ETFs, but stopped short of relaxing the rules on such funds.
To explain why transparency is such an issue for active managers and equity ETFs, Peter Sleep, senior portfolio manager at Seven Investment Management, compares a successful bond manager with a star equity manager.
He said: ‘If the market knows [an equity manager] likes a stock, they might front run him and drive up the price of a stock he wants to buy. I am not totally sure I buy this argument, except for very illiquid stocks, but this is what they argue.
‘A bond portfolio manager does not tend to focus on a specific bond, they will build up their positions in different currencies, maybe countries, durations, sectors, which are usually very liquid. They are not too bothered if their strategy is known because the bond market in the segment they are active in is probably very liquid.
‘As a result an equity manager is often quite secretive about what he is actively buying, whereas a bond portfolio manager can be more open. This makes active bond funds more suitable for ETFs than equity funds.’
Sleep added money market ETFs seem to be the most popular for firms to launch in an active format.
He said: ‘The most popular active ETFs, seem to be the cash active funds (you cannot really have passive cash ETFs) because these managers do not really care if the market knows what bonds they own, they are going to mature in a month or two and the portfolio manager intends to hold them to maturity anyway.’
The point about active bond ETFs being preferable for fund firms over equity ones is echoed by Marc Knowles, an ETF consultant at KPMG, who knows of active managers ‘who have a secret sauce’ deciding not to launch active equity ETFs.
On the bond side however, he said: ‘Asset managers are more comfortable publishing their fixed income holdings. The reason being it’s more challenging to determine any IP (intellectual property) from fixed income strategies.’
What to do?
Knowles said one alternative for fund firms could be to instead launch systematic ETF strategies, which use a more rules-based approach with a quantitative and mechanical investment process.
Knowles said: ‘A lot of asset managers have been thinking about how they can launch [active equity] ETFs, and one way they can do that is to take their IP and put it into a systematic strategy, where they can effectively build their own benchmark.’
Either way, traditional fund houses have been slow into the active ETF space, in particular on the equity side, and Sleep thinks some asset managers question whether it is ‘worth the effort’ to launch an active ETF.
He said: ‘I think another reason why there are not too many active ETFs is many managers wonder if it is worth
‘They already have a funds distribution network and why go to the bother of setting up a parallel ETF and ETF distribution network. They do not see the need. I think this is a stronger argument [for not launching an active ETF].’