Is it time for ETFs to get active?

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Active investing vs. passive: tastes great, less filling?

If you’ve ever used a Groupon, toggled between Expedia and Kayak and Travelocity, or waited until Prime Day to do your shopping, the current state of affairs in financial services may sound familiar.

Like consumers of all types, investors are opting for discounts whenever possible, and if that means avoiding money managers who take a hands-on approach, so be it. The ratings firm Morningstar grabbed headlines this summer by announcing that the amount of assets in so-called “passively-managed” mutual and exchange-traded funds topped those that are actively managed for the first time.

Among ETFs in particular, the division is even starker: a whopping 98% of all ETF funds are passively managed, meaning they follow a pre-determined index, an imbalance that often makes it seem like “ETF” is synonymous with “passive.”

But active investors aren’t conceding defeat. As ETFs mature and the appeal of their structure becomes more accepted, fund managers will increasingly opt to use an ETF framework, rather than a mutual fund, as the backbone for their investing strategies.

There’s a lot of daylight between 98% and 2%, but thanks to regulatory changes and industry innovations, active managers who have long been eager to narrow the gap now have more ways to approach it. That could mean more choices—as well as more difficult decisions—for investors.

“I just think the pendulum has swung so far,” Catherine Wood, CEO and founder of ARK Invest, told MarketWatch in a recent interview. ARK Invest manages five ETFs focused on “disruptive innovation,” among them the Genomic Revolution ETF ARKG, +0.70%   and one focused on Fintech ARKF, -0.88%  .

“So many investors are focused on performing exactly in line with the indexes, but we see so much opportunity that’s future-oriented that’s not captured in the indexes. I think active management is going to have its day in the sun and the indexers will lag behind innovation,” she said.

Related: Three fund managers may soon control nearly half of all corporate voting power, researchers warn

Born from a crisis

To properly consider the future of ETFs, it’s important to understand their past.

ETFs were born in the aftermath of the 1987 crash known as “Black Monday.” The Securities and Exchange Commission wanted a single tradable security that represented the entire stock market to offer liquidity in the hope of preventing future market meltdowns.

“So many investors are focused on performing exactly in line with the indexes. But we see so much opportunity that’s future-oriented that’s not captured in the indexes.”

Cathie Wood, ARK Invest

The first-ever ETF, the SPDR S&P 500 fund, SPY, +0.02%  debuted in 1993 and is far and away the most popular ETF of any type, with nearly $275 billion in assets under management and a daily average volume of almost $18 billion, according to FactSet data.

ETFs like SPY have flourished not only because of their rock-bottom fees, but also because they outperform their more expensive counterparts.

A September report from Morningstar showed that only 23% of all active funds topped the average of their passive rivals over the past 10 years. What’s more, the cheapest funds succeeded more than twice as often as the priciest ones (33% versus 14%) during that same period.

Regulatory changes

A September SEC ruling which overhauled the way ETFs are brought to market, in particular eliminating the regulatory distinction between the two categories, may help hasten Wood’s expected “day in the sun” for active funds.

“We continue to believe that index-based and actively managed ETFs do not present significantly different concerns,” the SEC wrote. Regulators said they believe the new rule will “help to provide a more consistent and transparent regulatory framework for ETFs.”

The rule is a boon to active managers, said David Mann, head of ETF Capital Markets for Franklin Templeton Investments. Franklin has seen investors shy away from products it offers simply because they have the “active” label despite having the same characteristics, including fees and liquidity, as most passive funds.

“’Passive’ doesn’t necessarily mean ‘cheap,’ and ‘active’ doesn’t have to mean ‘expensive,’” Mann said.

See: What is an ETF?

But the rule isn’t just semantic. It also allows active managers access to so-called custom baskets, allowing them to hold securities that may not precisely mimic the ones in their portfolio for when investors buy and sell shares of the fund. That tool was previously only available to passive funds. It will improve liquidity, not just for the issuer, but also for institutional investors who may want to swap shares of certain single securities for a fund that offers more diversification.

Is opacity a step forward?

Another factor that may boost a renaissance in active funds is a new type of ETF known as “nontransparent.” The new structure offers a way for managers to buy and sell actively in a fund structure many find preferable to mutual funds while revealing their holdings only once a quarter, as mutual funds do. Many active managers view this type of limited disclosure as key: investing holdings and strategies are Wall Street’s secret sauce.

“’Passive’ doesn’t necessarily mean ‘cheap,’ and ‘active’ doesn’t have to mean ‘expensive’”

David Mann, Franklin Templeton

Several asset managers have signed up to license the product from a company called Precidian, which was the first company to receive SEC approval for its version of the nontransparent approach. But since the new innovations do away with precisely what’s made ETFs so popular, including transparency on holdings and the ability to find an investing flavor that appeals in an index, many analysts aren’t sure what to make of it.

While some industry commentary has called nontransparent a solution in search of a problem, Todd Rosenbluth, head of ETF and mutual-fund research at CFRA, says he has a relatively optimistic view of its prospects. “We believe there’s an audience of investors that like active managers, or like their own active manager, but don’t have an ETF alternative,” Rosenbluth told MarketWatch.

To be sure, for people lured away from pricier alternatives to dirt-cheap options like iShares’ answer to SPY, the Core S&P 500 ETF IVV, +0.02%  , “those investors are not coming back,” Rosenbluth said.

But as long as the asset managers using the new fund structure pass on the savings of running an ETF to their customers, they are likely to also attract investors, Rosenbluth believes.

Advisors like James Werner, who helps manage about $240 million for high-net-worth households at Austin-based Silicon Hills Wealth Management, love ETFs of all flavors, including active.

Over the years, Silicon Hills has shifted most of its mutual fund business to ETFs, which now represent about two-thirds of the firm’s assets. The firm favors ETFs not just for the lower management fees but also the more favorable tax implications.

Werner sees value in passive strategies that add a layer of active positioning, such as “factor investing.” With a highly educated, mostly progressive client base, he also appreciates the way ETFs make socially responsible investing accessible.

But more often than not, Silicon Hills’ decision to use an active strategy is “to generate a little extra income over and above the index or to provide a little more downside protection,” he said. One such example: the “Defined Outcome” buffer products PJUN, -0.04%  profiled by MarketWatch in August.

It’s important to note that mutual funds are still a dominant force in their own right. The Wall Street Journal recently reported that 345 mutual funds were launched last year, to 247 ETFs, citing fund-advocacy group Investment Company Institute. And mutual funds still maintain nearly $20 trillion in assets under management as of Aug. 31, according to Morningstar data.

Read: Here’s why ETFs can’t bring down the financial system, iShares says

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