Exchange-traded funds (ETFs) have surged in popularity thanks to their many benefits like lower costs and daily tradability. The bulk of investors’ money in ETFs has been mostly regulated to so-called passive funds. That is, ETFs that track indices. However, actively managed ETFs have become all the rage. And in fact, the number of active ETF launches has recently surpassed the number of new passive funds coming to the market.
Those launches are being led by many guru and superstar managers of the mutual and hedge fund world.
The question is, will these managers find success in the ETF world or is this potentially a repeat of what we’ve seen in the mutual fund world?
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Launch Activity Surges
According to data compiled by Bloomberg, there have been a total of 166 new ETFs to hit the market this year. What’s interesting is the make-up of those funds. Typically, passive and index vehicles have led the charge in new launches. This year, active funds are having the upper hand. Of the total number of new funds launched, 151 of them have been actively managed.
Aside from the structural changes in the ETF landscape that allow managers to hide their holdings, the recent fury in active launch activity could come down to one word. And that’s “guru.”
Cathie Wood and ARK Investment could be the poster child for the growth in guru-backed active ETFs. With stellar returns and more than $20 billion in assets, Wood’s ARK Innovation ETF (ARKK) has become the pinnacle of success for active ETFs. And sensing the shift – and the potential fee income – many active managers are following Wood’s lead in active ETF management.
For example, fintwit social media star Ross Gerber of Gerber-Kawasaki recently launched an active ETF focused on growth opportunities, while Mario Gabelli has launched two active ETFs with seven more in the works. These two follow launches from superstars like Bond King Jeffrey Gundlach, PIMCO’s Jerome Schneider, T Rowe Price’s Thomas J. Huber, as well as many others.
Superstar fund managers are flocking to active ETFs as a way to expand their offerings and perhaps regain some of the lost mojo from their active mutual funds.
Can the ETF Wrapper Help?
For investors, it’s all smooth sailing ahead, right? We can leave our index funds behind and get higher returns via these active ETFs? Well, maybe not, and history from the mutual fund world shows light on this problem.
For one thing, there’s still a fee hurdle to overcome with many active ETFs. Yes, overall fees for active ETFs are far less than their active mutual fund sisters. But for many gurus and superstar-backed funds, fees are still on the high side. The previously mentioned Ross Gerber-managed AdvisorShares Gerber Kawasaki ETF (GK) charges 0.81% in expenses. That’s still a pretty high fee hurdle to clear.
And, typically, active managers can clear that hurdle…to a point. The second problem with active management comes down to what’s called asset bloat.
After a while of top-notch returns, investors flock to guru managers in an effort to get those higher returns. The issue is, funds get too big holding all that investor money. As a result, fund managers can’t be as nimble or perhaps buy the kind of stocks they really want to own. After all, if you have an $8 billion fund, buying shares in an upcoming small-cap stock won’t move the needle on the returns front. That causes several funds to simply become closet index funds, owning shares of large-cap stocks that their managers can buy en masse.
We have the history of the mutual fund space as a guide for this.
Google any of the superstar mutual fund managers of the late 1990s and early 2000s, and you have a who’s who of funds that sort of petered out as assets grew. A prime example of this asset bloat would be superstar Peter Lynch and Fidelity’s Magellan Fund (FMAGX). Lynch managed to grow FMAGX from a small sub-$20 million fund into a $15 billion behemoth when he retired. And since then, Magellan has grown further making it one of the largest mutual funds on the planet. But the returns have been nowhere as great as when Lynch was in charge. It’s just too big.
A study by C. Thomas Howard, PhD, at AthenaInvest shows that portfolio drag due to size can reduce returns by an average of 2.71%.
Seeing the Cracks
For active ETFs and the gurus that run them, this asset bloat is a creeping problem. As more investors look towards these funds for their portfolios and chase returns, they’ll hit the limit sooner than later. Given the quickness that ETFs seem to be generating assets, that day may come sooner than later.
For some funds, it could be here. ARKK’s Cathie Wood is sort of hitting the limits on what she can in quantity to make a real difference. Looking at her top ten holdings – and it’s all large-cap tech stocks – all of the smaller names are gone. There’s nothing wrong with owning Telsa or Roku shares, but their torrid growth days could be over.
Will Wood be able to generate the same sort of high returns as she did before? History says no.
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Taking a Cautionary Approach
For investors looking at active ETFs, understanding that the wrapper can’t overcome some issues is critical. Active managers will still have to deal with the same problems that they did before when their funds get too big. What that means is choosing ETFs that aren’t too large, and then really getting under the hood and making sure that they aren’t buying a closet index fund. That becomes a little more difficult when many of the new active ETF structures are semi-transparent with their daily holdings.
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