How The ETF Structure Will Save Active Management

When it comes to the onrush of actively managed ETFs, media skeptics abound. Those that have covered indexed ETFs question why investors would want to add what they term "active management" risk along with relentless empirical confirmation of systematic underperformance. This article endeavors to supply the answer to the title question.

The key argument is that active management simply doesn't work. It continues that data-driven results show that poor stock selection and more frequent trading inevitably result in underperformance. After all, the magnitude of the systematic underperformance of actively managed mutual funds vs. the S&P 500 Index - an average of greater than 70% in 5-year intervals since the SPIVA (S&P Index Versus Active) studies began. That's before tax. After-tax and fees, the news only gets worse for actively managed fund shareholders.

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Let us accept that the grossly inferior after-tax returns by actively managed and traditionally structured mutual funds is systematic. Why does this happen?

Using Monte Carlo simulation for random pricing of holdings and all possible combinations of 50 stocks from the S&P 500, 75% underperformance of those portfolios between 3 and 4 standard deviations from the mean. Therefore the probability that bad stock selection is the cause behind systematic underperformance is very highly unlikely.

The major culprit is the antiquated traditional structure which forced the fund itself to. accept and redeem daily cash flows. This costs the fund unnecessarily because:

  1. Cash must be kept on hand for redemptions - in a normal upward-trending market, cash earns less than stocks creating "cash drag."
  2. When redemptions exceed cash on hand, then stocks must be sold. Since the time interval precludes the tax-efficient in-kind methods, trades must be made on the exchanges. This creates capital gains, diminishing investors' after-tax returns.
  3. Worse yet - and this is usually overlooked - since fund companies are aware of investor sensitivity to capital gains - they usually incorporate automated processes that minimize capital gains incurred. This necessitates liquidating the portfolio's newest additions - the active manager's freshest ideas - in lieu of selling legacy holdings with huge implied capital gains. Bottom line: investors no longer hold the manager's most favored allocation to stocks purely as a consequence of the antiquated structure.
  4. Investors who buy and sell on the exchange know exactly what price they will receive for the fund shares they sold. They will receive the cash they need with no strings attached in t+2, soon to be t+1 according to The Depository Trust & Clearing Corporation (DTCC). Mutual fund redeemers can receive a much lower price than when they entered the sell order to the fund company due to forward pricing at NAV. Furthermore, fund-holders are subject to restrictions, in many cases incur a redemption fee of 0,75%, and receive funds redeemed in t+3.
  5. There are also fewer operational costs incurred by the fund company. Cash management, transfer agency, and trading desk functions are minimized by more than 80%.

This is where the industry jargon calling the ETF structure "a mere wrapper" is off-base. It modernizes a structural problem dating back to 1940. The bottom line is higher pretax returns and significantly higher post-tax returns for investors, FA clients, RIA clients, and the clients of Wealth Managers. All of these groups have become aware of these differences and essentially demanded active management options using the ETF structure because they stopped using options in the traditional structure. The time of reckoning seems near as ETFs in many markets have already surpassed or are on a course to surpass traditionally structured mutual funds globally in Assets Under Management.  Active managers will need to adapt. 

The good news for them is that many of their structural disadvantages as compared to index ETFs disappear as they adopt the more modern structure. Using the ETF structure essentially levels the playing field. Active managers such as DoubleLine (DBLV), Davis Asset management (DUSA), and Ark Asset Management (ARKK and ARKW) have delivered after-tax returns that are competitive with and/or superior to their benchmark ETFs. Therefore, I believe we have identified the culprit behind the systematic underperformance detailed by SPIVA. To paraphrase James Carville: "It's the structure, stupid!"

However, even with these facts and structural improvement, active managers in the US have been slow to embrace the ETF structure until this year. A major objection was the perceived need for full transparency. Portfolio managers were used to working trades over several days and thought that their trades would be vulnerable to being front-run by hedge funds and other managers. Fund companies assumed that the SEC would require fully transparent ETF basket trading for the foreseeable future and therefore, adoption of the ETF structure would put their managers at a disadvantage. This assumption turned out to be wrong. The latest technological and regulatory advances allow for customized semi-transparent trading baskets. Tax efficiency is achieved by not needing to sell securities on the exchange. There are three types of semi-transparency basket trading technologies to help actively managed ETFs defend their funds' trading vulnerabilities. The most tax-efficient and institutional-friendly of these is the Shielded Alpha® structure patented by the Blue Tractor Group. Technologies such as Shielded Alpha allow active managers not to worry about the intricacies of trading and to focus on investment decisions.  Examples of ETFs performing well using semi-transparent trading baskets are Stance Capital (STNC) and American Century Sustainable Equity ETF (ESGA).

Another relevant point is that the SPIVA studies have a specific bias baked in. The benchmark should not be an index. The fairest comparison to see if the playing field has been leveled is to use an ETF such as IVV or VTI in lieu of a no-transaction cost index. Comparisons to benchmark index funds using identical structures will give them higher probabilities of beating their benchmarks than in the current status quo.

The media and investment critics are unlikely to be satisfied that all of the above completely answers the title question. If actively managed returns on average have only a 50% chance on average to post an above-index-fund return, why wouldn't all investors just buy the benchmark index funds and eliminate "active manager" risk? The answer is that not all investors are comfortable with robotic management. Despite frequent education from the experts, costly actively managed mutual funds still dominate. Many sleep better and feel less anxious during market sell-offs with an active manager at the helm. They don't want the robot to dive their retirement off a cliff and feel that active managers are better suited to switch gears if necessary to preserve their capital. In reality, this may not turn out to be the case but for many investors, a raised comfort level is worth paying for. Therefore, the rush towards actively managed ETFs is neither a craze nor a marketing gimmick. It comes from long-overdue technological and regulatory disruptions.

Preserving a competitive market structure is another reason. It has been postulated by many of the industry's top quantitative minds that there exists a threshold percentage, x%, over which the market has become too crowded into the same trade with not enough non-indexed liquidity remaining for indexing strategies to work. However, in the superfast information age, continuing to underperform at a 75% clip on a pretax basis is not going to cut it. In short, actively managed mutual funds need to adopt the ETF structure and index ETF investors will eventually need them to do so.

What disruptions come next? In reality, the massive roles 401Ks, 403Bs, and 529 plans play in the money management industry are the only remaining factors keeping the traditional mutual fund family structure alive. The major technical reason the providers give for not moving to ETFs is that they cannot allocate proportionately because they cannot buy and sell fractional shares. These inefficiencies also will be changed by a combination of technology and regulatory updates in the near future.

The bottom line is that most Americans prefer active management. ETFs will raise the net returns systematically just on the structural change keeping buy and sell decisions identical. Therefore, actively managed equity ETFs will become the standard in the fund industry even while the demand for indexed ETFs also continues.


To learn more about how the ETF structure results in a level playing field for actively managed portfolio returns, read my last article in ResearchGate.

Disclaimer: Always read the fact sheets and/or summary prospectus before buying any ETF.  Past performance is not necessarily indicative of future results.

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