Will active ETFs threaten unit trusts?

As the global exchange-traded fund (ETF) market has matured, products have evolved, with active ETFs emerging as a small but increasing segment.

According to independent research group ETFGI, global demand for these investments is on the rise, with 2017 inflows into active ETFs and products listed globally increasing by 57.3% to reach $75.2bn in total assets under management at the end of December.

While the SA financial services sector has been slow to track this global trend, the status quo is about to change. Geoff Cook, executive director and co-founder of ZAR X, states that one of the biggest misunderstandings among investors is that an ETF has to be an index tracker. "An ETF can consist of any portfolio of assets, which is why we are in the process of listing a dynamic ETF that has a managed portfolio behind it."

Cook explains that an active ETF is similar to a unit trust in terms of its structure and mandate. It is the process of investing that differs. "By effectively listing a unit trust structure on an exchange with a transparent mandate, and operating it as a dynamically managed fund, you create cost and operational efficiencies and boost liquidity, which is an attractive value proposition for investors."

Active ETFs offer all the advantages of unit trusts, but with lower barriers to entry in terms of cost and administrative requirements. Investors also benefit from greater trading flexibility and transparency of underlying holdings. These benefits spurred the growth in the global active ETF market.

While fees for active management would generally exceed those of passive ETFs, the potential exists for issuers to outperform benchmark returns from cap-weighted indexes as fund managers can change allocations, perform market-time trades or deviate from the index as they see fit to take advantage of market moves, which could offset the difference in fees.

Active ETFs would have similar reporting requirements as other collective investment schemes, which ensures good governance and regulatory compliance, adds Cook.

These capabilities have also become more compelling to fund managers since the US-China trade war has led to a decline in markets, with both the S&P 500 and the Nasdaq 100 shedding significant value this year. Amid the rise in global tensions, investors are understandably looking for ways to counter the dip.

While additional concerns have been raised regarding the tax efficiency of active ETFs due to higher trading volumes, proponents are particularly bullish about the future prospects of this investment instrument. In fact, numerous claims have been made that active ETFs will usurp traditional mutual funds within the next 15 years.

While it’s a provocative stance, CFA charter holder and director at etfSA.co.za Nerina Visser doesn’t believe that active ETFs will be the death knell for unit trusts.

"The established investment distribution model, particularly in SA, where unit trusts dominate, won’t change any time soon. However, the introduction of an active ETF into the local market would definitely signify a shift in trend."

Visser believes the active ETF model makes sense because the electronic share register removes much of the burdensome back-office administrative requirements inherent in unit trusts. "In addition, ETFs offer the ability to trade existing units in the secondary market, which is a benefit that unit trust issuers don’t enjoy. The frictional transaction cost associated with creation and redemption of units in unit trusts is an onerous and inefficient process.

"However, if you listed that unit trust on an exchange, this underlying frictional cost would fall away, which would offer benefits in terms of improved cost efficiency and enhanced liquidity that could deliver more robust returns."

Visser adds that a reduction in administrative requirements and costs would lower barriers to entry, helping to drive broader inclusion among retail investors. "A case can certainly be made for actively managed listed unit trusts as the next evolution of this entrenched investment product."

Among those who remain sceptical of industry claims that active ETFs will replace traditional unit trusts, many cite the implications of transparency as a primary reason why asset managers, particularly equity managers, would not implement their investment strategies via ETF platforms.

While nontransparent active ETFs would protect their investment strategies, Visser believes regulators like the Financial Services Conduct Authority are loath to change the strong value proposition that has been built around ETFs as index-tracking investments, as this could confuse investors.

Expect greater variety and innovation from index providers, including factor-based indexes and fixed-income ETFs.