Active ETFs suffer from one drawback

Unlike mutual funds, ETFs cannot limit capacity

Tom Eckett

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Soft closing a fund is an important tool for active managers who do not want to compromise their investment process.

When a fund – especially one that invests in a concentrated basket of securities – becomes too big, it can force the manager to invest in more liquid assets that may not align with the strategy’s investment process.

This leads to style drift, a key concern of fund selectors who spend months researching the right strategy to incorporate in their portfolios.

“Fund companies take these actions because they believe that if the fund gets any bigger, it will impact on the investment process and performance may be compromised. These actions are taken to protect existing investors,” fund research house and platform Chelsea Financial Services explained.

While the ETF structure has many benefits, one drawback for active managers is they cannot soft or hard close a strategy to the same effect.

Because ETFs are listed on exchanges, much like stocks, they trade on both the primary and secondary markets.

Mutual funds, meanwhile, only operate on the primary market while investment trusts trade on the secondary market.

If an active ETF was to suspend primary market creations-redemptions due to capacity issues, it would trade like an investment trust, with potentially high premiums and discounts to net-asset value (NAV).

“Strategy capacity is critical in the ETF structure. Focusing on ETFs that hold liquid securities and reasonably diversified portfolios is a good way to limit capacity risk,” Monika Calay, director, manager research at Morningstar, said.

Why would an active manager launch an ETF they plan to soft close and treat like an investment trust? It makes little sense and could potentially damage the ETF wrapper’s reputation among fund selectors.

“Any active manager considering using ETFs must assume that they will lose a key power, namely that of saying ‘no’ to new investors,” Calay continued. “The ETF structure does not allow – at least not yet – for the possibility to enact soft, let alone hard, closures to new investors.

“While open-ended funds can enact subscription fees to curb inflows, ETFs can only charge creation-redemption charges on the primary market – they cannot institute any barriers to entry on the secondary market, where most trading takes place.”

This is one reason why active managers with concentrated portfolios have so far been reticent about launching ETFs in Europe. Instead, the trend from ETF issuers has been to focus on ‘index-plus’ strategies that invest in larger baskets and deliver incremental outperformance.

Europe’s largest active ETF, for example, the $7.8bn JPM US Research Enhanced Index Equity (ESG) UCITS ETF (JREU), currently invests in 249 stocks, a size that is unlikely to be limited by liquidity constraints, especially when focused on large caps.

Calay concluded: “The potential for capacity issues is clear, particularly for the more concentrated strategies, and while some asset managers may market strategies less aggressively as they start nearing capacity, they have no practical, direct way of preventing asset bloat.”

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.

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