Note: a version of this article first appeared on ETF.com.

With Fidelity’s recent registration for a new version of actively-managed ETFs (see these ETF.com articles authored by Matt Hougan and David Nadig), I think it is only a matter of time before much of the traditional actively-managed mutual fund universe migrates over to some form of ETF structure, even if it is in the hybrid form proposed by Fidelity.  Whether this will help stem the outflow of investor assets from active to passive management remains to be seen, given that ETFs are not the primary reason why passive leader Vanguard is gaining the lion share of this outflow from active management. 

As an aside, I do believe traditional active management can play a role in investment programs primarily because professional investors ultimately determine where best to allocate investor capital depending on price and opportunity (see “Here’s How Active Can Compete with Low Cost ETFs”).  Active management also brings social benefits as professional managers provide feedback signals to corporate management on the effectiveness of their capital allocation decisions.  However, there are continuous debates on 1) where active management should be employed (i.e. public vs private markets, equities versus fixed income, small versus large caps) and 2) how it should be employed (i.e. quantitative versus fundamental, diversified versus concentrated/high conviction). 

One area of opportunity ripe for active management is in thematic-based ETF investing.  As an ETF strategist, I’ve been drawn to some of the thematic-based ETFs that are constructed not around groupings (i.e. sectors) or factors (i.e. low volatility) but around ‘themes’ as a way to capture more qualitative growth trends using screens.  Some of the more popular themes include technological innovation and security (HACK, ARKK, PRNT), longevity (OLD, LNGR), and health and wellness (BFIT, FITS). 

What has held me back in considering these thematic ETFs largely come down to 1) expenses and 2) questionable portfolio construction. 

Sector Funds Wrapped in Thematic Clothing

Unfortunately, there is no direct way to screen for thematic-based ETFs.  However, one can start with ETFs identified as ‘Sector Equity’ within Morningstar’s US Category Grouping, which is where most thematic ETFs are categorized.  There are 346 sector ETFs in Morningstar’s database (as of the time of this writing) that charge an average net expense ratio of 0.49%.  Indeed, most thematic ETFs can be thought of as sector-based ETFs where certain sectors are mapped by the ETF provider that fit the targeted theme and then invest in stocks with those sector IDs.  There are two main sector identification systems: Global Industry Classification Standard (GICS) or North American Industry Classification System (NAICS).   The process identifies the GICS or NAICS IDs that fit the thematic profile and builds a basket around those sectors: it’s nothing more complicated than that.  Yet, thematic ETFs tend to charge much higher fees versus plain-vanilla sector funds (roughly 20-70 basis points higher than what Fidelity, SPDRs and iShares charge on their sector ETFs).  Now this may be an unfair generalization of the thematic process as some firms use a proprietary methodology for identifying stocks that fit the specific theme, but then, even for these funds, their proprietary methodology would undermine the transparency of the ETF itself reducing its overall appeal. 

In addition, many thematic-based ETFs tend to treat portfolio construction as an afterthought where security weighting is either based on market capitalization or just equal-weighting.  Most of the ETF sponsor’s ‘intellectual property’ goes into the screening mechanism for ETF basket inclusion and not much into how the basket should be constructed.  In other words, membership becomes the sole determinant for portfolio construction.  By way of example, several ETFs that play on the ‘longevity’ theme end up being a play on healthcare REITs as nursing home facilities are one way of playing ‘longevity’.  Other thematic ETFs can have heavily concentrated positions in individual names with little to no transparency as to what is driving those concentrated positions. 

Flawed Index Methodology Opens the Door for Active Management

Investor sentiment has clearly soured on active management as this year’s net outflows from equity mutual funds can attest. Indeed, S&P/Dow Jones just updated a study affirming the lack of persistency of top performing funds (top performing funds over a trailing period fail to maintain their dominance over subsequent periods), calling further into doubt the value proposition of active management.   In a previous article published on ETF.com, I argued that we need to shift our thinking on the value-added which comes from active management as the advent of ETFs can replicate much of what traditional active management has historically delivered. 

One area where active management shines is in risky-debt investing such as high yield, emerging markets, MLPs, convertibles, etc.  The risk in these sub-asset classes is asymmetric where successful investing means minimizing your exposure to losers rather than picking winners.  In addition, fixed income index methodologies are inherently flawed as they assign the highest weights to the largest issuers (in other words, the most levered issuers).  Now you’re seeing more ETF sponsors come out with fundamentally-weighted fixed income indices (PHB, VBND, WFHY to name a few); however, skilled managers demonstrating credit research and trading expertise are worth paying up for to navigate the risky debt markets. 

This all serves as a lead-up to where I believe traditional active management can successfully launch ETFs, namely actively-managed thematic ETFs.  We, of course, know why active ETFs have received a tepid reception from the marketplace, since ETF investors demand immediate liquidity, daily transparency, tax efficiency, and low fees, much of which can be better delivered by passive vehicles than active.  Plus, many ETF strategists (not us, but many of our peers) tend to employ higher turnover trading strategies that don’t necessarily lend themselves to buy-and-hold time horizons that help provide a more stable capital base for active managers to work with. 

That said, rather than launching an ETF version of a ‘Growth-and-Income’ mutual fund, traditional (fundamental) active managers should consider launching actively-managed thematic ETFs.  Thematic-based investing is increasing in popularity (witness socially-responsible investing), yet the delivery of these themes in a rules-driven passive approach is somewhat suspect given the costs and questionable execution.  Anecdotally, I have spoken with several sector-focused portfolio managers, such as those focused on alternative energy, where there exist nuances that are not easily capturable in a rules-driven approach.  For instance, alternative energy can be reflected in areas beyond a standard GICS classification (i.e. solar or wind) such as cutting edge technology, operating logistics (energy intensity in delivery of final product), and so forth.  As another example, a skilled manager focused on longevity can select the two or three best nursing home facilities rather than investing in all of them. 

Hesitation on Delivering Active Management to ETFs

Yes, there are issues for traditional active managers entering the ETF space, namely lack of reception, lower fees, and daily transparency (prospects for front-running).  However, when compared to mutual funds, Matt Hougan argues that the benefits of ETFs over mutual funds are significant: “lower costs, greater tax efficiency, more trading flexibility and a fairer allocation of entry and exit costs.”

What would also hold back adoption would be a lack of a long track record (ironic since the S&P Dow Jones study cited earlier helps undermine the use of trailing performance when picking managers).  In addition, the daily transparency and expectations of ETF investors leave little room for style drift or deviation away from the mandate (i.e. no buying internet stocks in an equity-income fund just to keep up with the markets).  These can be addressed by the ETF sponsor by working with an index provider to come up with a customized thematic benchmark that can help anchor investor expectations on what it is they’re actually buying.  This benchmark would not prevent an actively-managed health-and-wellness ETF from holding tobacco stocks, but the daily transparency would make it obvious that the manager is deviating away from the mandate.  In addition, actively-managed ETFs would ferret out portfolio managers who rely more on trading prowess to add alpha rather than superior research since the daily transparency of ETFs would discourage active trading due to concerns over front-running. 

If the fees charged on thematic ETFs are an indication of what the market will bear, then it’s a no-brainer for active management because actively-managed thematic ETFs can demonstrate their value-added just by addressing the inherent flaws identified with passive, rules-based thematic ETFs.  The Fidelity filing serves as a potential entry point for active managers to launch ETFs.  The next wave of ETF innovation could very well come from the one area seeing declining investor interest, but active managers must ensure that their value propositions are clearly aligned with the attributes desired by ETF investors, namely transparency, fidelity to the underlying mandate, and cost-effective execution of the strategy. 

 

Disclosures:

At the time of this writing, 3D Asset Management did not hold any of the ETFs mentioned in this article. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of August 17, 2016, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing sales@3dadvisor.com or visiting 3D’s website atwww.3dadvisor.com.