When to consider active ETFs

Canada has the largest penetration of active ETFs in the world, and investors should recognize that the cost disparity between actively-managed ETFs and F class mutual funds has closed

Ruth Saldanha 7 May, 2019 | 5:00PM

 

 


Ruth Saldanha: We recently discussed the blurring lines between active and passive fund management. Increasingly, active managers are using passive management tools like data-driven financial analysis or screeners as the first stage of their processes, while passive strategies have active elements like selecting factors for strategic beta products. When should you pick active and when should you use passive funds? Mark Noble, Senior Vice President of ETF Strategy at Horizons, is here to talk about this. Mark, thank you so much for being here today.

Mark Noble: Great to be here.

Saldanha: First up, do you see these lines blurring anymore?

Noble: Yes, I think they are blurred and especially in Canada. Canada has the largest penetration of active ETFs in the world and a lot of people are familiar with this. In fact, we represent about 20% of the active ETFs. And last year, half the product launches were actively managed and almost half, 42% of the inflows, were active. So, for ETF investors, the lines are blurred. And sometimes I think that from an industry perspective, we don't even discuss now the difference between active and passive. Just ETFs are sort of launched and it's, sort of, up to the investor to figure out like is this an active strategy, is this a factor strategy or is this a passive strategy. And further blurring lines to your point is that in the United States there is a real demarcation between the factor strategies and the passive strategies, but in Canada the demarcation doesn't exist to the same degree. And of course, from a pricing perspective, the active and the strategic are almost the same. So, it does get very difficult to sort of navigate, you know, what is this ETF doing, how is it getting exposure.

Saldanha: So, for a Canadian investor, in what circumstance should you consider looking at an active versus a passive ETF?

Noble: Well, first and foremost, I think the main point and I think it is gratifying to see is it doesn't matter as much as your asset allocation decision. So, if you choose to invest in, let's say, the financial sector or fixed income, having that (card in) your portfolio is more important than where you use active, strategic or passive; you've made the right call in building your portfolio. But then when we do drill down into it, where most of the launches and mandates are, are on markets that are less efficient. So, if you are in the S&P 500 or large-cap Canadian equities, it's extraordinarily difficult to beat that with an active or even a factor strategy. You see that roughly 90% of managers on average over the last 5 years are unable to beat the S&P 500. So, for default, S&P 500 makes sense.

That gets flipped on its head though when we look at something like Canadian fixed income asset classes, Canadian preferred shares, corporate bonds where there is less efficiency, less depth for the market, less information out there. These are tightly controlled markets. And we see that there is a lot of statistics to suggest that an active strategy in these less efficient markets has some real value. So, you see, and you do see in the products that a lot of the products are being launched with more of the income bias, particularly the fixed income, or in emerging themes, things like marijuana or technology, where again, there is less information flow, less understanding of the market mechanics and that's where maybe there's a little bit of alpha that could be generated by an active manager.

Saldanha: One of the main attractions of ETFs is the fact that the costs are lower. But now, mutual fund costs reducing and the active funds being slightly more expensive, that cost benefit analysis gets a bit trickier, isn't it?

Noble: It does get tricky and it's a great question. Because I think that the mutual fund – I'm an ETF guy through and through, I've been doing this for 10 years. But I do think that the mutual fund industry gets a little bit of a bad wrap in terms of their fees because their fees and bundled. So, you have all types of different costs built in there including the training costs, many cases including the advice costs. So, majority of mutual funds are in advice A class mutual funds. If I take a look at an F class mutual fund and compare it to an actively-managed ETF, you end up seeing similar costs. And if I factor in something like bid/ask spreads, you start to see the costs almost come oranges to apples – or sorry, oranges to oranges, not an apples to orange equation.

So, from my perspective, what ETFs do, the key advantage is the liquidity and the ability to trade them on a day-to-day basis and get information flow of them being up there, but I do think that investors have to recognize that the cost disparity between actively-managed ETFs and F class mutual funds has closed. On the extreme end, however, when we are talking about large-cap index strategies, those fees have almost gone to zero. So, there's a clear demarcation there. The average cost of the Canadian equity index ETFs are well below 30 basis points. But on the active side, you may find that there is a fund that has a similar cost point as the ETF, which means that as an advisor or an investor it's really incumbent on you to look at what are you getting for on that fee and recognize, like, does the ETF structure make more sense because of the way you are going to trade it or would it make more sense to use the mutual fund on the case of the client. And that's really, again, where I think advice comes into play.

Saldanha: Thank you so much for joining us today, Mark.

Noble: Always a pleasure to be here.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca