Ducks, Lamborghinis and Active ETFs
“When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck.”
The Duck Test, first believed to have been coined by the Indiana poet James Whitcomb Riley, is a classic example of abductive reasoning. Abductive reasoning is where we arrive at the simplest and most likely conclusion from an initial observation or set of observations. Despite my best intentions, the Duck Test is what always comes to mind when I read any ETF related news. ETFs are no longer the purebred passive animal of yore. Although an apparent contradiction in terms, actively managed ETFs are becoming increasingly en vogue with 2020 being the first year where more actively managed ETFs have launched in the US than their passive counterparts. So, is the passive ETF a sitting duck (sorry) and in danger of extinction despite passive funds more generally experiencing a continuing surge in popularity? With the US ‘officially’ in recession since the National Bureau of Economic Research’s announcement2 on June 8th, will current market conditions prove a blessing in disguise for the burgeoning active ETF industry and the jumpstart needed by active managers or will we start to see investors look to de-risk and retreat by the duckload (ok I’ll stop now) for the comparative security of passive investing? Moreover, does this present any challenges for those working in compliance when it comes to the transparency of the investment strategy implemented?
If we first look at the trend over the last decade, according to Morningstar’s year-end 2019 report3 only 23% of active funds outperformed the average of their passive rivals over the 10 year period ended December 2019. Additionally, the Morningstar report notes that over this same 10 year period the cheapest funds had a success rate of 34% as opposed to only 14% for their pricier counterparts3. This latter point is interesting as it highlights the inherent contradiction in active management, namely that of the fees that must be levied to cover the services offered. I particularly like John Rekenthaler of Morningstar’s analogy4 “If funds were sports cars, the steeper their price tags, the slower would be their acceleration. A Lamborghini would struggle to outpace a golf cart.” The actively managed fund is the Lamborghini in this instance with its ‘pace’ being slowed by higher expense ratios. These expense ratios are higher due to the additional research and analysis costs incurred as part of the portfolio management process when compared with the much lower costs incurred by passive funds that simply track the constituents of a benchmark index. This is nothing new of course and has been one of the primary drivers behind the continuous decline in expense rations experienced for the past two decades. The average expense ratio paid by fund investors has been falling for two decades. The asset-weighted average expense ratio paid by investors in 2019 across all mutual and exchange traded funds was approximately half what was being paid 20 years ago. Although fee reductions have been evident across both active and passively managed funds, the average asset-weighted fee in 2019 for passive funds stood at 0.13% versus 0.66% for their active challengers5. When you look at these figures in conjunction with the sobering fact that the Morningstar analysis also noted a survival rate of 68% for the cheapest funds as opposed to 55% for the more expensive over the same 10 year period, it is no wonder that passive strategies have grown in popularity at the expense of their active counterparts. Focusing on ETFs, the expense ratio of an active ETF will typically be higher than that of a passive ETF but lower than that of an active mutual fund.
Looking at 2020, the increased uncertainty caused by market events of the last year, from Brexit to US-China relations and now COVID-19, is adding further fuel to the fire in respect of the outlook for active funds. As of June 4th, 42 active funds and 35 with passive strategies have been listed1. In the first quarter of 2020, it has been estimated that active ETFs took in $3bn of new investor money. A number all the more impressive considering that COVID-Chaos had already taken hold at this point and that active mutual funds hemorrhaged an eye-watering $267bn in the same period. According to a recent analysis published in the Financial Times6, active managers including Invesco, Franklin Templeton, Pimco, T Rowe Price and Capital Group, all suffered net redemptions of between $17.9bn and $32.2bn in the first six months of 2020. In contrast, during the same period passive funds managed by Vanguard had net inflows of $67.7bn, State Street Global Advisors with $20bn and iShares ETFs accounted for the majority of BlackRock’s $74bn in net inflows. Despite the impressive $3bn in active ETF inflows for the first quarter of this year, passive ETF inflows were 20 times higher at $60bn for the same period. An unfair comparison perhaps given the active ETF’s status as new kid on the block but it places the net outflows of $267bn from actively managed mutual funds for the same period in even starker contrast. It’s still too soon to say whether the market turmoil caused by COVID-19 will buck the long-term trend we have seen towards passive management. General wisdom states that active management is actually a better strategy in recessionary times due to a greater ability to quickly respond and provide downside protection but to date there has been little evidence of this. If this is true, in my view active ETFs are a kind of halfway house in the fund world in terms of risk and fees and could be well placed to experience even further growth in volatile markets, at the expense of traditional mutual funds.
The active/passive debate has also been evident in the EU. Unsurprisingly, the trend is much the same. On April 6th of this year, the European securities regulator, the European Securities Markets Authority (“ESMA”) published its second annual statistical report7 on the cost and performance of retail investment products in the EU. When I read that actively managed UCITS funds saw gross outperformance over passive and ETF UCITS funds in 2019 it initially gave me pause for thought. Why would the situation be different in the EU? However, reading on I saw that this difference was not high enough to compensate the higher costs charged by active UCITS funds, which averaged 1.5% compared with 0.6% for passive and ETFs. The active UCITS Lamborghini is being outpaced by the passive UCITS golf cart.
Is a deliberate lack of transparency on behalf of active managers also prompting investors to increasingly explore passive alternatives? In the EU, the issue of ‘closet indexing’ has been an area of recent focus by both ESMA and national regulators. ‘Closet indexing’ has been defined by ESMA as a practice whereby asset managers claim to manage their funds in an active manner and charge management fees accordingly while the funds are in reality staying very close to a benchmark. The results of a review published in February 2016 and conducted by ESMA between 2012 and 2014 concluded that between 5 and 15% of UCITS equity funds were potentially closet indexers. This then prompted ESMA to work with national regulators in the EU to determine if fuller investigations on a fund-by-fund basis was required. Following the results of a review conducted by the Central Bank of Ireland (“CBI”) on Irish domiciled UCITS funds and published in July 2019, the CBI identified 182 UCITS funds allegedly involved in closet indexing. The CBI required managers of a number of these funds to update the necessary disclosures in their fund documentation and to communicate this to investors along with providing information on the regulatory investigation that led to the changes. The CSSF in Luxembourg identified one potential case in 2017 and the UK’s FCA has estimated that as much as £109bn of investor money is sitting in potential closet trackers. UK fund managers were required to pay £34m8 in compensation to investors in 2018 because of overcharging for supposed active strategies. This presents unique challenges for compliance and fiduciary personnel where compliance with investment restrictions is not necessarily sufficient, the relevance and appropriateness of those restrictions needs to also be assessed as being in line with how the fund is defined and marketed in respect of its investment strategy and the associated risks. Although unlikely to be a uniquely
European phenomenon, the issue of closet indexing is not one that appears to have yet garnered much attention this side of the Atlantic.
So, to recap, active fund launches and inflows have been lagging behind their passive counterparts for quite some time and 2020 thus far shows no indications of bucking that trend. One obvious reason for this is that of performance but regulatory scrutiny (at least in Europe) on fund managers misleading investors in respect of fund classifications will not help their case. Active ETFs are certainly an outlier and one to watch as the year progresses. Active mangers of traditional mutual funds need to get their ducks in a row however to avoid falling increasingly fowl of funds with passive strategies. Perhaps active funds are not all they’re quacked up to be?