Getting active with ETFs

There is no set definition of an active ETF, but it generally refers to a manager being involved in choosing the investments. giving the possibility of outperformance of an index, rather than just tracking it.

"Our actively managed ETFs use a systematic approach and a range of parameters to select the most attractive stocks as a first step, but then we add a health check where the fund managers manually check each stock and, for example, exclude those that have high bankruptcy risk," says Stefan Fröhlich, fund manager of the JB Smart Equity UCITS ETFs. "ETFs have the advantage of being very liquid and transparent, and can be traded intra-day at real-time prices. Active management allows them to focus on the most attractive companies rather than blindly replicating an index."

Examples of a 'health check' include when the managers of the JB Smart Equity UCITS ETFs overruled their systematic stock selection model and sold Brazilian oil company OGX Petroleo in August 2013. It was expanding rapidly but had overoptimistic output targets and poor well output. In October 2013 OGX Petroleo missed bond repayments and filed for bankruptcy.

The JB Smart Equity UCITS ETFs are listed in Germany and Switzerland, but are registered for distribution in the UK.

"Some active ETFs such as ours have a manager to do the asset allocation who has a fair amount of discretion but is limited by certain rules," says Arne Noack, head of exchange traded product development for Europe at db x-trackers. "This could be, for example, a limit on how much the ETF can put into equities.

"Smart beta ETFs do not have an active manager so do not involve discretion, rather they follow an index which follows a defined set of rules. Active ETFs can therefore be much more flexible and their managers may take a tactical view on the quality or cheapness of an asset - and may or may not adhere to certain systematic sets of rules."

So called smart beta ETFs, which are more common in the UK, typically still follow an index but of which the constituents are determined by a factor other than market capitalisation. Regular indices and the ETFs which track them are constructed so that the biggest, most widely traded investments account for the biggest proportion, whereas smart beta indices may be weighted by yield, volatility or a ratio such as price to book. Or the investments might be determined by an algorithm (computer program).

Examples of smart beta ETFs include IC Top 50 ETFs SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV), which aims to track the performance of 30 high dividend-yielding equity securities issued by UK companies, and Powershares FTSE RAFI All World 3000 UCITS ETF (PSRW), which follows an index of cheap stocks, constructed by focusing on companies' economics rather than their stock market value.

One of the main attractions of active ETFs is that they typically have considerably lower charges than unit trusts and open-ended investment companies (Oeics). Mr Noack says active ETFs can be a simple way for private investors to get a diversified asset allocation globally and tap into the expertise of a manager at a potentially more competitive fee level compared with traditional mutual funds. "It also offers daily liquidity as you can just buy it from a broker like a share," he adds.

"An advantage of active ETFs is that investors can also sell it at any time," adds John Davies of SPDJ.

And this is likely to be at around its net asset value (NAV).

Active ETFs can provide different exposures to passive ETFs. "For example, it is very difficult to have a physical cash ETF - you cannot invest in Libor - so physical cash ETFs such Pimco Sterling Short Maturity Source ETF pretty much have to be active," says Peter Sleep, senior investment manager at Seven Investment Management.

IC Top 50 ETF Pimco Sterling Short Maturity Source ETF (QUID) aims to maximise current income while preserving capital and maintaining a high degree of liquidity. It has an active fund manager, but also the structure and low costs of an ETF. It mainly invests in short-term investment grade debt denominated in sterling, and its ongoing charge of 0.35 per cent makes it much cheaper than active bond funds and money market funds. It can be used for cash allocation in a balanced fund or as a low-risk haven while waiting to buy back into equities.

Read more on poor cash alternatives

Read more on expensive money market funds

Active ETFs such as the Source Man GLG Asia Plus (MPAS), Continental Europe Plus (MPCE) and Europe Plus (MPFE) UCITS ETFs, meanwhile, allow private investors to access quant investment strategies that typically only institutions have access to.

UK listed active ETFs: Performance and charges

Source: Morningstar, as at 23 July 2014, *ETF provider & ** Morningstar

Risk comparison

Active ETFs share some of the same risks as active funds, for example their managers might under- rather than out-perform their benchmarks due to making the wrong call.

Active ETFs tend to have higher fees than passive ones, and Mr Noack says investors need to consider if the possibility of outperformance through active management is worth the potential extra costs of active ETFs.

Active ETFs may not publish all their holdings as is common with mainstream passive ETFs: the Julius Baer active ETFs, for example, publish their top 20 holdings daily.

Pimco Sterling Short Maturity Source ETF and Pimco US Dollar Short Maturity Source UCITS ETF (MINT) publish all their holdings, but the Source Man GLG ETFs publish the holdings of the strategy they offer exposure to with a delay of around two weeks.

However, this is more transparent than a standard open-ended fund or investment trust that typically publishes its top 10 holding once a month. Investment trusts also often put their full list of holdings at the end of their financial year into their annual reports, although these are generally published more than a month after the end of the trust's financial year.

"Overall, I would not currently recommend any of these active ETFs," says Adam Laird, passive investment manager at Hargreaves Lansdown. "The total expense ratios on most of them are high and often comparable with standard actively managed funds. Some of these active ETFs have quite short records and the performance record on many is patchy. Even for those that have outperformed so far, investors could get their fingers burnt."

Investment trusts

In the UK, investors already have access to listed mutual funds - investments trusts. However, these have a number of differences when compared with active ETFs.

Investment trusts cannot create or redeem units like ETFs, the only way to access them is via their fixed number of shares. This means that they trade at premiums or discounts to NAV depending on buying and selling demand. "This is a blessing and a curse - investment trusts can present an opportunity to buy £1 of assets at 95p, but there is the possibility for discount to widen further," says Mr Laird. Investment trusts can issue more shares or buy back shares to control the discount or premium but this tends to be on an infrequent basis.

ETFs generally trade close to their intraday NAV because, despite being listed as open-ended, they can create or redeem units on a daily basis for authorised participants - typically market makers or large institutions. If an ETF's share price rises above the value of its underlying securities the authorised participants can buy the shares that compose the ETF and then sell the ETF's shares. This should help drive the ETF's share price back towards fair value, while the authorised participants earn an arbitrage profit.

If the ETF starts trading at a discount to the securities it holds, the authorised participants can buy large numbers of the ETF shares cheaply and redeem them for the underlying securities, which can be resold. Buying of the undervalued ETF's shares drives the price of them back towards fair value while once again making a profit for the authorised participants.

For private investors not inclined to volatility, this could be an advantage; however, if you like to try to take advantage of discounts you think might narrow or close, this is not possible with ETFs.

Investment trusts also have the power to take on debt to invest in assets, but ETFs that comply with the Undertakings for Collective Investment in Transferable Securities (Ucits) regulations cannot. They can use derivatives to this effect, albeit in accordance with strict criteria, although they don't necessarily do this. For example, db X-trackers SCM Multi Assets UCITS (XS7M), an active ETF, does not use derivatives to take on leverage or invest in funds that can.

This gives investment trusts the potential to make greater returns, but also makes them riskier because if markets go down the debt can magnify losses.

Because investment trusts are closed-ended they are better suited to investing in illiquid assets such as physical property, infrastructure or private equity. Because ETFs have to redeem and create units they need to have reasonably liquid assets.

Most investment trusts have longer lifespans and track records than active ETFs with which to assess them.

Some active ETFs have what is known as a synthetic structure. Rather than buy the assets they invest in, as investment trusts do, they get the return of what they track via a swap counterparty, usually an investment bank or insurance company, which pays the ETF the returns of what it is tracking, often in exchange for the returns of a collateral basket held by the ETF. This introduces the risk that the swap counterparty defaults, say, because it has become insolvent and is not able to honour its obligation. But ETF providers have taken a number of steps to mitigate this risk, and Source, for example, uses multiple swap counterparties on its synthetic ETFs so if one fails there are others to fall back on.

If a synthetic ETF is compliant with Ucits fund legislation, it is obliged to hold collateral worth at least 90 per cent of the value of its assets to mitigate losses.

The Source Man GLG Asia Plus, Continental Europe Plus and Europe Plus ETFs (see table, above) are active ETFs that have a synthetic structure.

Investment trusts (and physical ETFs) also incur counterparty risk if they lend securities to boost revenues. The main risk is that the borrower does not return the assets, for example because it has become insolvent.

But investment trusts are now subject to European legislation known as the Alternative Investment Fund Managers Directive (AIFMD) which requires them to appoint a depositary which ensures a trust's assets are appropriately protected. As the depositary is liable for the trust's assets it has to make good any loss.

The JB Smart Equity ETFs have a physical structure so invest in stocks. They also don't use derivatives or leverage the portfolio. "And we don't allow securities lending and borrowing, hence investors have no third-party risk," adds Mr Fröhlich.

While active ETFs are generally cheaper than open-ended funds this is not necessarily the case with mainstream investment trusts.

For example, the JB Smart Equity UCITS ETF World has a total expense ratio of 0.7 per cent, but some global sector investment trusts have ongoing charges around that level or cheaper.

20 cheapest global growth investment trusts

*IC Top 100 Fund

Source: Morningstar, as at 23 July 2014