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Actively managed exchange-traded funds (ETFs), which have long been overshadowed by their passive index peers, are gaining momentum amid a changing regulatory landscape.
A recent report from Boston-based Cerulli Associates Inc. indicates that U.S. asset managers now see this niche as the most significant opportunity – more so than the strategic beta or passive fund offerings. Active ETFs have slowly been gaining ground in Canada for the past decade.
“We are seeing a similar phenomenon in Canada [as in the U.S.], but we’ve had more of a runway, so it doesn’t seem as big of a leap,” says Daniel Straus, director of ETF research and strategy at National Bank Financial Inc.
Active ETFs, which are funds that don’t track a published index, represented 25 per cent of the $323-billion in Canadian-listed ETF assets under management (AUM) at the end of 2021, Mr. Straus says. In the U.S., they made up 4 per cent of the US$7.2-trillion in ETF AUM.
Regulatory changes in 2019 for U.S.-listed ETFs have now opened the floodgates for active ETF growth south of the border, Mr. Straus says. “More than half of the new launches last year in the U.S. have been in active ETFs.”
The poster child for active management in an ETF wrapper has been stock-picker Catherine Wood, founder of ARK Investment Management LLC. Her flagship ARK Innovation ETF ARKK-A, which is also fully transparent in showing its holdings daily, posted an eye-popping total return of 157 per cent in 2020. It has since struggled as growth stocks have taken a hit amid rising interest rates.
In Canada, “mutual fund providers, insurance companies, small boutique start-ups, and hedge fund managers are launching active products,” Mr. Straus says.
Active ETFs can range from investment managers picking individual securities to overseeing options strategies, such as in BMO Assset Management Inc.’s covered-call ETFs.
The advantage of active ETFs is their lower fees versus their mutual fund counterparts, he says.
If an ETF’s fee is the same as the F-class mutual funds, which excludes the sale charge, then the benefit really comes down to the ease of use to buy and sell and the ability to do intraday trades, he adds.
Canadian active ETFs came out of the gate faster than their U.S. peers because they have always been regulated like mutual funds. These ETFs can be described as semi-transparent because they only require quarterly disclosure of a portfolio’s major holdings with a short lag versus the daily disclosure required for passive ETFs.
“We are a few steps ahead, and that’s why there have been many Canadian ETFs launched in the past two or three years around hedge fund strategies,” he says.
In 2019, Canadian securities regulators revamped rules for mutual funds and ETFs to allow for the creation of liquid alternative investments (a.k.a. liquid alts) that include long-short equity, arbitrage, and market-neutral funds.
It’s clear that Canadian liquid alts ETFs have had “more leeway to execute pure hedge fund strategies” than their U.S. peers, he says, referring to rules on leverage and concentrated positions.
Some of the players in the alternative ETF space range from well-known Toronto-based hedge fund manager Picton Mahoney Asset Management to start-ups such as Accelerate Financial Technologies Inc., which is based in Calgary.
Toronto-based Horizons ETFs Management (Canada) Inc. launched the first Canadian active ETF in 2009, but that fund subsequently closed. Today, the ETF provider has about 30 offerings under the active ETF umbrella.
More recently, Canadian fund companies have jumped into the space, too. Purpose Investments Inc., PIMCO Canada Corp., Starlight Capital and Ninepoint Partners LP are among firms that run an ETF series for some of its mutual funds.
In other cases, a portfolio manager overseeing an ETF and mutual fund in the same asset class may take a slightly different approach for the investments.
For example, David Fingold of 1832 Asset Management LP oversees Dynamic Global Dividend Fund, a mutual fund that can hold cash, and Dynamic Active Global Dividend ETF DXG-T, which is fully invested. The premise is that ETF investors want to do their own asset allocation or market timing, Mr. Straus says.
More U.S. mutual fund companies to launch active ETFs
In the U.S., all ETFs were required to reveal holdings daily until a rule change in 2019 that allowed asset managers to launch semi-transparent or non-transparent ETFs. Before that, many asset managers backed off from active ETFs for fear that front runners would buy their stocks and drive up their prices.
The new regulations on transparency have prompted more U.S. mutual fund companies – from T. Rowe Price Group Inc. to Fidelity Investments Inc. and American Century Investments – to launch active ETFs using different structures.
Others, such as Dimensional Fund Advisors LP, have opted to convert some of their mutual funds to active, transparent ETFs. JPMorgan Chase & Co. also plans to do the same for several funds in the coming months.
Capital Group, which runs mutual funds in the U.S. and Canada, plans to launch a slate of six active, transparent U.S.-listed ETFs this quarter. However, these ETFs will not be clones of the firm’s U.S. mutual funds.
Daniil Shapiro, associate director at Cerulli Associates, says it’s a natural step for U.S. fund companies to enter the active ETF market given that actively managed mutual funds have seen outflows since 2015.
“They want to avoid losing flows to passive ETFs,” he says. “It’s a logical extension of their capabilities given that investors are increasingly interested in the ETF structure.”
The active ETF strategy is a white-space opportunity in which asset managers can launch products that can potentially be successful as the market is saturated with passive and even rules-based, strategic beta, also called smart beta, ETFs, Mr. Shapiro adds.
However, U.S. asset managers need to figure out which active ETF strategy will work best for them, he says. Although some firms are converting mutual funds to ETFs, it’s a complex process that can also require shareholder approval.
They should also keep an eye on Vanguard Group Inc.’s unique dual-class structure, which comes off patent next year, he adds. That approach is more like the Canadian model in which the ETF is just another series of a mutual fund.
Interestingly, Cerulli’s research also indicates that the once-feared, transparent, active ETF option appears to be gaining traction. Seventy per cent of polled ETF issuers are developing or planning to develop these kinds of ETFs.
This wave of active, transparent ETFs expected from U.S. firms could stem from the industry watching ARK Investment’s success and believing that they too can offer an active strategy without losing too much, Mr. Shapiro says.
“We think it’s easier to gather assets in a transparent structure,” he adds. “That’s because it’s one less thing for advisors to be concerned about. The ETF structure, after all, is about transparency.”
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