Why launch an active ETF?
More fund managers than ever before are launching active ETFs in response to investor demand. Over the last five years, active ETFs have added 20% per annum each year to their AuM. They also now represent a larger slice of the overall ETF market. Investors have allocated over USD 375 billion to actively managed ETFs in the last five years alone, according to data from Morningstar.
While investors continue to allocate more to mutual funds, the gap is closing.
There are other reasons for launching an active ETF: the average ETF is 36% cheaper than the average mutual fund. While many mutual fund managers have shied away from launching an ETF due to concerns about transparency, the early adopters have seemingly not encountered any issues from providing the kind of transparency an ETF needs.
ETFs represent a more tax-efficient wrapper for fund managers, especially in the US, and can be cost-effective to run versus the traditional mutual fund model, especially if you are working with the right technology partner.
Knowing the market
Listing ETFs on an exchange is an exercise that goes beyond simply launching the security and waiting for the money to arrive. An active ETF, although a public security, is still a tool for marketing your investment strategy to an investor audience.
For managers starting to lose assets from a mutual fund, an active ETF launch may make sense, as it allows them to target the market with an additional, lower-cost investment vehicle.
However, an active ETF also represents an opportunity to reach new investors and new markets, for example, for an institutional fund manager contemplating a retail launch for the first time.
Unlike mutual funds, an active ETF will also require the use of an Authorised Participant and a market maker network.
Authorised Participants are financial institutions which create and redeem the shares of ETFs in the primary market, including those of active ETFs. The process helps to keep the price of the ETF aligned with the value of the securities held in the fund. They work in a similar way to broker-dealers in the open-ended funds space.
Automation challenges
Supporting a listed ETF will require that a fund manager adopt new operational procedures that go well beyond the capabilities of Excel spreadsheets.
Below are just some of the automation challenges that a fund manager will need to incorporate into their pre-launch requirements:
- Dynamic communication of portfolio information to the market – working with market makers to ensure that they can support a tight spread on buying and selling the fund.
- Management of the dealing process, including faster turnaround of subscriptions and redemptions
- Cash management process, in kind and in cash deals, and combinations of the two
- Integrating directly with service providers intraday to deliver structured data, which means fully automated and straight-through
Launching an active ETF in the US
US exchanges will now allow semi-transparent active ETFs to be listed, as well as the previously approved fully transparent funds. US exchanges are trying to keep the listing process as streamlined as possible for active funds, including retaining the majority of the tax efficiency aspects of passive ETFs.
Active ETFs can make use of multiple proxy design options which will help the fund manager to protect his alpha.
Converting a US mutual fund into an ETF can be achieved within an existing trust structure under the terms of the 1940 Investment Company Act, but it can also be reorganised by proxying it into a new trust. Shareholder approval will be needed in the latter case.
For a direct conversion the fund manager will not need to use a proxy agent and does not need to actively engage with the existing investor base.
Note that a mutual fund that converts into an ETF in the US becomes subject to more oversight, by both the board of the ETF and also in terms of the various service provider relationships required to support the ETF.
A reorganised fund can be housed in a new shell, with board and SEC approval. This will require a new filing and a shareholder vote. The process may also require use of a proxy agent.
Launching an active ETF in the European Union
Thus far, the market for active ETFs in Europe is still relatively new, but some major fund managers, including BlackRock, Ark Invest, and BNP Paribas, have launched active ETFs in Europe. Other major firms are undoubtedly planning their own launches.
Fund managers who want to launch an active ETF in Europe can use similar channels to those already established by passive funds. Europe is the second largest ETF market after the US, and appetite for ETFs in the region is increasing.
Active ETFs in Europe can be launched under the rules of the EU’s UCITS Directive. The UCITS regulations may mean that an active ETF will need to be managed slightly differently from an existing mutual fund strategy, but this could also avoid the new fund cannibalising the mutual fund (see below for more on this), as it would represent a slightly different strategy.
Fund managers will need to be aware that under UCITS rules, there are restrictions on remuneration, concentration of holdings and underlying investments (e.g. commodities), which will also apply to active ETFs.
As with the US, fund managers are faced with a choice of exchanges to list on in Europe. Thought must also be given to which domicile to use – most UCITS fund managers are still using Ireland or Luxembourg for this.
Will your active ETF cannibalise your existing mutual funds?
Industry intelligence indicates a strong preference for the ETF structure over mutual funds. According to data from Trackinsight, in its fifth annual Global ETF survey, 80% of investors would prefer to see an active investment strategy packaged as an ETF.
This is also matched with increasing interest in ETFs generally on both sides of the Atlantic. Almost 75% of investors are either already invested in ETFs or are planning to do so imminently.
Larger fund managers have already accepted that the launch of the same strategy as an ETF could cannibalise their existing mutual funds, but these are sometimes funds that are already seeing outflows to cheaper competitors. Product strategists will need to make a decision based on the existing status of a specific fund.
How Truss Edge supports issuers
Our multi-strategy portfolio management system was created more than 20 years ago, and for over 12 years, we have worked alongside leading ETF issuers to provide a complete technology and operations platform for all types of ETFs. Truss Edge’s Safari system delivers a full roadmap for issuers operating an ETF, meaning they can retain complete control over the investment process as opposed to using sub-advisor arrangements. This means a PMS solution regardless of strategy or investment instruments, whether synthetically or physically replicated index-based funds or active funds, European UCITS or US 40-Act.