ETF Insight: The future of active ETFs in Australia

Active ETFs

Active ETFs have been given a new lease of life following the Australian Securities and Investments Commission’s (ASIC) decision to lift a six-month ban on ETF issuers launching active products late last year.

The regulator had previously expressed concerns about the transparency and disclosure of active ETFs. It was especially worried about active ETFs that do not publish their holdings daily.

With the ban now lifted, investors are expecting a slew of active ETFs to hit the market in 2020. To coincide with the ban being lifted, ASIC has asked the ETF industry to avoid issuing ETFs with an internal market maker.

BlackRock’s head of iShares Christian Obrist says transparency is critical in the active ETF space. “This relates to transparency in asset allocation disclosure and in fee structures. We also need transparency in market-making structures, which can often be more complex compared to traditional ETFs.”

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Obrist stresses Australia needs a framework for ETF trading that works in investors’ interests. “Any framework must not leave room for conflicts of interest such as the ability for the product issuer to control the price to enter or exit the fund. We support ASIC’s ongoing efforts to ensure a safe and efficient market across our industry.”

He would also like to see clearer naming conventions for exchange-traded products. “An ETP classification system benefits investors by setting expectations about the structure and inherent risks of a product and could also assist regulators in developing appropriate rules.”

Fee trends

While active ETF fees are higher than for passive ETFs, market dynamics are evolving.

“Fee compression is inevitable as the ETF market evolves,” Obrist continues. Increasingly, investors also appreciate the need to pay different fees for different strategies. They expect a different price for a fixed income versus smart beta versus sustainable active ETF.

Fees also depend on the manager, strategy and sector. For example, Magellan’s high conviction trust has a fee of 1.5%. At the other end of the fee range is the Vanguard Global Multi-Factor Active ETF, which has a fee of 0.28%. But in general, active ETF fees are between 0.5% and 1%.

When assessing fees, it is important for investors to factor in brokerage on each transaction. Investors are paying too much if brokerage is more than $20 a trade. Look at another broker if brokerage is anywhere near this amount.

What about managed funds?

For investors considering active ETFs, it is important to understand their relative advantages and disadvantages versus passive ETFs and managed funds.

Investing in a passive ETFs essentially means you accept average returns. Some argue that this makes sense when markets are flat or even falling, as investors like to know their portfolio is not falling more than average. But it makes less sense when the market is rising because it does not give investors the opportunity to partake in any market-beating upside. Investing in active ETFs gives you the chance to outperform the index.

Investors also use active ETFs when buying the index does not make sense for other reasons. “Buying the index may expose investors to stocks they do not really want but are forced to own. An active ETF gives you the best of both worlds by offering liquidity and low fees and a more concentrated, high conviction approach to investing,” certified financial planner James Gerrard explained.

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It is simpler to invest in an active ETF versus a managed fund because the former can be instantly accessed through an online broker and can be bought and sold like a share. By contrast, it can take much longer to invest in an unlisted managed fund, which requires investors to complete and file paperwork to apply for units in the trust, a process that can take days or weeks.

“The right active ETF will depend on what else you have in your portfolio. You do not want to invest in a new, active ETF which has similar underlying holdings as your existing portfolio because it will not add diversification benefits,” said Pete Pennicott, a director of financial advice firm Pekada.

“For example, you might look to complement your broad global market exposure with an active ETF manager that focuses on companies with strong ESG profiles.”

Risk factors

Active manager underperformance is the main risk with active ETFs. Vanguard’s research indicates more than 90% of active ETFs underperformed over a 10-year period so it is essential for investors to monitor any active ETFs in which they are invested.

If an active ETF is underperforming, it is important to understand why. “Find out if it is underperforming due to a sustained period of bad calls rather than events which could not have been reasonably predicted,” Gerrard added.

With many new active ETFs expected to hit the market this year, it is critical to have confidence in the quality of the issuer.

Penicott said: “You want high quality and liquidity to ensure you can access your funds quickly and at fair value. By their nature, active ETFs have tracking error relative to traditional indices. So ensure you are comfortable with this and take it into account when constructing your portfolio.”

ETF Insight is a new series brought to you by ETF Stream. Each week, we shine a light on the key issues from across the ETF industry, analysing and interpreting the latest trends in the space. For last week’s insight, click here.

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