Not satisfied with having ushered in a new era of efficient, low cost, investment-savvy pooled investment products, ETF issuers insist on trying to reengineer their own (already pretty darn good) invention. Active ETFs are the newest entrant in the ETF product category, and they are designed to add value over the performance of an index — that is to say, add alpha.
To do this, active-ETF makers go down a complicated path that involves replicating an active portfolio based on the characteristics of the underlying securities. Index ETFs, by contrast, seek to replicate a specific index with all of its embedded market risk (beta) at the lowest possible cost without adding value above the index return. The introduction of the more complicated version of ETFs highlights an important rule of product management: It is not the complicated product features that break, but the minor stuff that causes the biggest problems for investors and advisors. Often product features work differently in real life than they do on the spreadsheet or database model once the human element is introduced.
The Market Vs. NAVs
ETFs are, without a doubt, both a brilliant idea and the product offering that is a harbinger of doom to chronically underachieving actively managed mutual funds. Offering convenience, reasonable and transparent fees, full tradability, and the ability to laser in on a particular market sector, they do also have a couple of features that could present challenges to portfolio managers, financial advisors and their clients. ETFs, like closed-end mutual funds (CEFs), have both a net asset value (NAV) and a market price. This is a fantastic opportunity if you are into arbitrage and can take advantage of a pricing discrepancy (which is small, typically just pennies). This is not such a convenience if you are looking for a core portfolio holding and do not expect to trade frequently and on the basis of pricing inefficiencies.
To understand what this might mean to investors, take a look at closed-end mutual funds. Traditional open-end mutual funds trade at their net asset value (NAV), which is usually the market value of the securities in the fund. With the exception of a sales charge, the underlying security prices and the price an investor pays are the same. With a closed-end fund, the NAV is just a data point, and the price an investor pays is either the price per share at issuance, or, in the secondary market, the market price.
To understand how this pricing structure plays out in closed-end fund land, we looked at an excellent website that tracks ETFs, closed-end funds, and more at www.ETFConnect.com. Analyzing the most up-to-date closed-end fund pricing information, we found that more closed-end funds trade at a discount than do at a premium, by a ratio of about 3:1, and that the median discount is nearly 300 basis points greater than the median premium. This dynamic is not new, and many advisors do quite well for their clients by shopping for higher yielding closed-end funds trading at discounts. That we might see this pattern play out for ETFs doesn't make them bad, it just means that like all financial products, it is important to understand just exactly how it works.
We asked a couple of portfolio managers who regularly use ETFs as part of their investment strategy what they think about ETFs these days, and about how they view the new active ETFs. Frank Sabin of Portland, Maine-based Weyland Capital Management expressed concern about the liquidity of new, and/or small ETFs focused on more “esoteric asset classes,” specifically raising concern about widening bid/ask spreads and issuers' ability to make a market in its own securities should a pricing discrepancy arise. David Baker of Boston's North American Management agrees, and wonders, “What happens when there is limited liquidity? Will the Street create a market” in the ETFs under pressure?
New And Misunderstood?
Today's ETF market is huge, with more than 650 ETFs and more than $600 billion in assets. So market liquidity is not likely to be an issue for the large and well-established ETFs, but it certainly could be problematic for new, small, thinly traded ones. Active ETFs, the newest kid on the ETF block, may get whacked around a bit from a pricing perspective until they are well-established and well-understood.
We are hopeful that ETFs will not suffer the steep price swings to which closed-end funds are subjected. Because there is no initial public offering at a pre-set share price, there is no reason for there to be a radical pricing change early in the product's life cycle. At the same time, it is not clear to us that all investors fully understand this product's (NAV and market price) pricing mechanisms, and misunderstanding is never good for financial products — their investors or investors' advisors. Discovering a bid/ask where you did not expect to see it may not be comforting. Advisors and investors using ETFs should be sure they understand all of the inner workings of ETFs to avoid surprises. Focusing on the most liquid markets and asset classes may be a good strategy for now, too.
