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Active ETFs May Not Kill Mutual Funds Just Yet

It’s no secret that actively managed exchange traded funds (ETFs) have taken the world by storm. Thanks to their benefits—such as intraday tradability, lower costs, and potential tax savings—investors and financial advisors have flocked to this fund type for their portfolio needs. Overall, active ETFs remain the fastest growing category for new launches and asset gathering when it comes to ETFs as a whole.

With that, many market pundits have proclaimed the death of the mutual fund as imminent.

However, we may want to rethink that stance, at least when it comes to some funds and types. Despite their appeal, active ETFs—particularly semi-transparent active ETFs—have some major flaws that mutual funds can get around. The end all, be all might be that investors will be using both fund types for the long term.

See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.

Semi-transparent ETFs Come Into the Spotlight

Active ETFs come in a variety of flavors. The vast bulk of them still fall under the Investment Company Act of 1940 and, as such, are considered fully transparent ETFs. Because of SEC rules, daily trading ability, and market-maker requirements, ETFs are required to list their holdings daily. For an index fund, that’s not such a big deal. When it comes to active management, however, this transparency can cause trouble.

The key to active management is the manager. Because they can buy and sell pretty much what they want, their methods and so-called ‘secret sauce’ are now made public daily if they use the ETF structure. For example, you could see what a guru like Cathie Woods was buying or selling. If her ARK Innovation ETF (ARKK) added a small-cap tech stock, you could go out and buy those shares too. This is called front running and many managers complain this limits their ability to get good deals on firms or build full positions. Meanwhile, investors can simply copy their holdings and bypass paying management fees for the ETF.

To that end, many fund companies petitioned the SEC for rule changes. The regulatory agencyobliged and created rules that provide relief from the Investment Company Act of 1940. This would allow fund disclosures on a quarterly or semi-annual basis, potentially eliminating the front-running issue.

With that, semi-transparent ETFs were born.

Growth Has Been Muted

With semi-transparent ETFs now a structure, active ETFs are now free to reign supreme over mutual funds, right? Well, not so much. While it is true that the number of active ETFs launched have surged and assets have grown, the growth in assets/numbers of semi-transparent ETFs have been more muted.

The reasons still lie within those pesky SEC rules.

Rule 6c-11, which gives the work-arounds on disclosure, features some surprises for investment managers. The biggest issue relates to the rules on how underlying holdings in the ETF trade. To not run afoul of Rule 6c-11, holdings in semi-transparent ETFs must trade on public exchanges at the same time as the ETF. While that seems like a no-brainer, it actually creates a problem.

For one thing, many foreign stocks trade as ADRs on the OTC or don’t trade during U.S. market hours. Because of that, ETF managers can have a hard time pricing them accurately. If one market is open while another is closed, it’s not SEC compliant for semi-transparent ETFs.

Second, bonds can have issues when it comes to semi-transparent structures. Believe it or not, most bonds don’t actually trade daily, sans U.S. treasury debt and large corporate issues. That’s one reason why active management works well in fixed income. But because many bonds trade in private placements, over the counter or through large transactions, they also don’t comply with Rule 6c-11.

Finally, even U.S. small-caps can have issues when it comes to semi-transparent ETFs. The smallest small-caps and micro-cap stocks don’t always trade well either and can be very illiquid.

Mutual Funds Skirt This Problem

Because of Rule 6c-11 and these issues, semi-transparent ETFs don’t always work for certain asset classes. In fact, this involves many of the asset classes that active management excels in. So, fund managers have a choice—use a fully transparent active strategy and risk front running and copy-catting, or continue doing what they are doing.

And that means offering mutual funds.

Because of their rules, mutual funds can skirt disclosure requirements—at least quarterly—and keep their holdings secret. This allows them to prevent front running, keep managers’ recipes hidden, and provide all the benefits of active management in key asset classes.

This seems like it’s the preferred choice for many asset managers. Despite many of the major mutual-fund-to-ETF conversions, copy-cat fund launches, and overall shift toward active ETFs, the bulk of fund launches have been in U.S. large-cap and U.S. corporate/treasury debt funds. Those that have looked at other assets have primarily done fully transparent ETFs and not semi-transparent structures.

Given that mutual funds work well for a variety of esoteric and hard-to-price asset classes, their death at the hands of active ETFs may be premature. Realistically, they’ll be around for the long haul, just like how closed-end funds (CEFs) remain a good bet for some asset classes as well.

The Bottom Line

In the end, investors stand to benefit from all fund structures and building a successful portfolio doesn’t lie within just one type of investment vehicle.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.