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1 ACTIVE ETFS 2012 Thomson Reuters All rights reserved.
2 ACTIVE ETFS 2012 MAY 2012 Active exchange-traded funds (ETFs) have made quite a splash in the last few months, most likely attributed to an onslaught of recent active ETF filings with the SEC 1 along with the launch of PIMCO s Total Return Bond ETF. This paper will explore this hot topic by making comparisons between active ETFs and ETFs that track an index. At the end, Lipper will make some recommendations for boards of directors of active ETFs. The main findings are as follows: 1. Active ETFs do not track an index; this makes them distinctly different from pure index ETFs. 2. Active ETFs are more expensive than ETFs that track an index. 3. Returns for active ETFs have been less volatile than returns for ETFs that track an index. 4. The median percentage change in total net assets caused by flows is higher for active ETFs in some years and lower in others, in comparison to ETFs based on an index. 5. Boards of directors for active ETFs should consider active ETFs separately from index ETFs for peer review in the contract renewal process. AUTHORED BY: SASHA FRANGER FIDUCIARY RESEARCH ANALYST FIDUCIARY SERVICES, LIPPER sasha.franger@thomsonreuters.com Please note that the views expressed in this document are intended as non-consultative and do not constitute legal advice. 1 Jackie Noblett Total Return, Other Active ETFs Inch Closer to Launch. 1
3 INTRODUCTION Lipper noted in previous research why ETFs, in general, are desirable in comparison to typical open-end mutual funds. 2 The reasons include low and easy to understand expenses, trading flexibility, tax efficiency, transparency, and, finally, index tracking that often gives investors access to niche markets. This has left some wondering where this leaves actively managed ETFs because they do not possess some of the positive attributes that index ETFs possess active ETFs do not track an index, nor are they as inexpensive. Despite these differences, active ETFs offer the other advantages and are still less expensive than traditional open-end mutual funds. Because of these differences, active ETFs have been receiving quite a bit of attention from the media and investors, along with fund companies as many prepare to launch new active ETFs. Lipper defines active ETFs as ETFs that do not intend to replicate or track an index and whose portfolio manager is empowered to choose securities for the fund s portfolio. Conversely, according to Lipper s definition, the objective of pure index ETFs is to match the total investment performance of a securities market index. The ETF must always invest the majority (typically at least 80%) of its assets and hold virtually all securities in the noted index in its entirety. 3 In practice, it is fairly straightforward to differentiate a pure index ETF from an actively managed ETF based on prospectus language. For example, the prospectus for one active ETF, the PIMCO Total Return Exchange-Traded Fund, states that the ETF seeks maximum total return, consistent with preservation of capital and prudent investment management. 4 Similarly, the prospectus for the WisdomTree Emerging Markets Local Debt Fund states that The Fund seeks a high level of total return consisting of both income and capital appreciation, and it also states, The Fund is an actively managed exchange traded fund. 5 Lipper defines active ETFs as ETFs that do not intend to replicate or track an index and whose portfolio manager is empowered to choose securities for the fund s portfolio. In contrast are two examples from the prospectuses of pure index ETFs. The ishares S&P US Preferred Stock Index ETF s primary objective is to achieve investment results that correspond generally to the price and yield performance, before fees and expenses, of the S&P US Preferred Stock Index. 6 The SPDR Dow Jones International Real Estate ETF uses slightly stronger wording by stating, The SPDR Dow Jones International Real Estate ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of an equity index based upon the international real estate market. 7 These examples demonstrate that actively managed ETFs and pure index ETFs are clearly distinguishable by the language in their literature. 2 Sasha Franger Walking the Walk: ETF Performance. 3 Lipper also identifies two other types of index ETFs enhanced index and index-based. Lipper defines index-based ETFs as ETFs that utilize any index as its primary filter for selecting securities in which to invest. These types of ETFs may have a portion of the fund that is actively managed. Lipper defines enhanced index ETFs as ETFs that try to exceed (or underperform) the index they track. Index enhanced ETFs and index-based ETFs are not included in this analysis. 4 PIMCO ETF Trust. Prospectus, October 31, WisdomTree. Summary Prospectus, December 29, ishares Prospectus, August 1, State Street Global Advisors. Summary Prospectus, January 31,
4 Active ETF assets have grown astronomically in the last four years. At the end of 2008, active ETF assets totaled $223.9 million, compared to nearly $2.5 billion at the end of 2011 (Figure 1). Much of this asset growth traces to newly launched active ETFs. As of March 31, 2012, there have been 44 active ETF initial public offerings (IPOs). In fact, February 2012 celebrates the fourth birthday for active ETFs with the February 2008 IPOs of Guggenheim Investments Enhanced Core Bond ETF and Guggenheim Investments Enhanced Short Bond ETF (both of these were formerly known as Claymore). Figure 2 displays new active ETF IPOs per year for the last four years. FIGURE 1 ACTIVE ETF ASSETS BY YEAR Total Net Assets ($Mil) 3, , , , , Active ETF assets have grown quite a bit since the advent of such funds in Note: This chart illustrates the growth in year-end active ETF total net assets FIGURE 2 NEW ACTIVE ETF IPOs BY YEAR Number of ETFs (through 3/2012) The number of new active ETFs was highest in Note: This chart illustrates new active ETF IPOs by year since their inception in
5 Currently there are 40 active ETFs that fall into an array of asset classes ranging from US Diversified Equity (USDE) to municipal debt with a high concentration in taxable fixed income (Figure 3). The next three sections will explore how active ETFs differ from pure index ETFs in expenses, performance, and flows. FIGURE 3 ACTIVE ETFs BY ASSET CLASS Number of ETFs Equity Fixed Income USDE Other Domestic Equity Sector Equity World Equity Mixed Assets Municipal Debt Taxable Fixed Income There are more fixed income active ETFs than equity active ETFs, and the asset class with the highest number of active ETFs is taxable fixed income. Note: The chart above displays the number of active ETFs by asset class as of March 31,
6 EXPENSES Actively managed ETFs differ from pure index ETFs because they do not track an index. The implication is that these types of ETFs may be more expensive than the pure index ETFs because of the active management. Evidence for this can be seen in traditional open-end mutual funds where frontend and no load actively managed funds have an average expense ratio of 0.918% compared to 0.558% for indexed funds. 8 Figures 4 and 5 display median expenses for equity and fixed income ETFs separately. As expected, active ETFs are more expensive than pure index ETFs from both a management fee and total expense perspective and for both equity and fixed income ETFs. For example, actively managed equity ETFs have median total expenses of 88.9 basis point (bps) compared to 52.5 bps for pure index ETFs. As a side note, the total expenses and management fees are virtually the same for traditional ETFs. This is because nearly all ETFs have an all-inclusive management fee, meaning that the management fee covers substantially all operating cost of a portfolio. The fee is paid to the advisor, who in turn pays the various service providers. FIGURE % 0.900% 0.800% 0.700% 0.600% 0.500% 0.400% 0.300% 0.200% 0.100% 0.000% MEDIAN EQUITY ETF EXPENSES Management Fees Active Total Expenses Indexed Median management fees and median total expenses are higher for equity active ETFs than index ETFs. Note: The chart displays median management fees and total expenses for active and index equity ETFs. The median for active ETFs is represented by the blue bar, and the median for indexed ETFs is represented by the green bar. For comparison purposes, Lipper found that the average total expense ratio for actively managed institutional equity funds is 1.145% and 0.558% for fixed income funds. 9 Although active ETFs are more expensive than their index counter-parts, they are still less expensive than their open-end mutual fund counterparts. The difference is most likely because of the overhead costs related to fund administration faced by traditional mutual funds versus ETFs. FIGURE % 0.350% 0.300% 0.250% MEDIAN FIXED INCOME ETF EXPENSES Active Indexed 0.200% 0.150% 0.100% 0.050% 0.000% Management Fees Total Expenses Median management fees and median total expenses are higher for fixed income active ETFs than index ETFs. 8 Sasha Franger Lipper Quick Guide to Fund Expenses 9 Sasha Franger Lipper Quick Guide to Fund Expenses Note: The chart displays median management fees and total expenses for active and index fixed income ETFs. The median for active ETFs is represented by the blue bar, and the median for indexed ETFs is represented by the green bar. 5
7 PERFORMANCE The next way Lipper will compare active and pure index ETFs is to compare their annualized and rolling performance since the inception of active ETFs. Figures 6 and 7 do just that. From an annualized performance point of view, active ETFs have underperformed (2.78%) compared to their pure index peers (3.20%) for the last four years. However, in the past year, active ETFs outperformed their pure index peers. The rolling annual performance chart offers some insight into the performance difference presented in the annualized performance chart. Annual returns for active ETFs have been fairly stable in comparison to pure index ETFs. Median active ETF annual performance ranged from 1.31% to 10.83% for the last four years, while median performance for pure index ETFs has experienced huge swings and has ranged from % to 55.59%, coinciding with the economic downturn and recovery. Because of the growth of active ETFs in the last four years, it is difficult to compare performance, and based on this data it remains to be seen as to whether active ETFs or pure index ETFs will perform better in the long run. FIGURE 6 MEDIAN ANNUALIZED PERFORMANCE Active Indexed 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Two Years Three Years Four Years Index ETFs out-perform active ETFs in all of the annualized periods except for the one-year period. Note: This chart compares median annualized performance of active and indexed ETFs. The median for active ETFs is represented by the blue bar, and the median for indexed ETFs is represented by the green bar. FIGURE 7 MEDIAN ROLLING ANNUAL PERFORMANCE 80.00% 60.00% 40.00% 20.00% Active Indexed The annual rolling performance for index ETFs is more volatile than the annual rolling performance for active ETFs. 0.00% % % % 03/31/12 03/31/11 03/31/10 03/31/09 Note: This chart compares median rolling performance of active and indexed ETFs. The median for active ETFs is represented by the blue bar, and the median for indexed ETFs is represented by the green bar. 6
8 FLOWS Finally, Lipper will compare the flows of active and pure index ETFs. Although the number of new active ETFs has grown steadily over the last four years, ETFs, in general, have become increasingly popular; therefore, it is difficult to predict whether active or pure index ETFs will have experienced higher annual flows. In order to put active and pure index ETFs on a level playing field when it comes to assets, this paper will use the percentage change in total net assets (TNA) caused by flows for the measure of flows instead of total flows. The median percentage change in TNA cause by flows is presented in Figure 8. Except in the one-year period ending March 31, 2009, the percentage TNA caused by flows pattern is similar for active ETFs and pure index ETFs. In the one year period ended March 31, 2009, the median percentage change in TNA caused by flows was much lower for pure index ETFs, corresponding with the negative performance they had that year (refer to Figure 7). In the most recent two years, pure index ETFs had higher median percentage change in TNA caused by flows than active ETFs, and active ETFs had higher median percentage change in TNA caused by flows in the latter two years. Like performance, it is difficult to extrapolate from this data into the future because of the newness of many of the active ETFs. It remains to be seen whether active ETFs or pure index ETFs will win more assets. FIGURE % % 80.00% 40.00% 0.00% % % MEDIAN PERCENTAGE CHANGE IN TNA CAUSED BY FLOWS 03/31/12 03/31/11 03/31/10 Active Indexed 03/31/09 In two of the years, active ETFs had greater percentage change in TNA caused by flows and in two years index ETFs had a greater percentage change. Note: This chart compares the median percentage change in TNA caused by flows for active and index ETFs. The median for active ETFs is represented by the blue bar and the median for index ETFs is represented by the green bar. 7
9 BOARD CONSIDERATIONS Based on the findings in this paper, board of directors should consider active ETFs separately from pure index ETFs. Not only do active ETFs have distinctly different objectives from pure index ETFs, but they differ in expenses, performance, and flows as well. In addition, boards may want to concentrate their expense analysis on the total expense ratio instead of the management fee ratio because many active ETFs have an all-inclusive management fee. 8
10 Thomson Reuters All Rights Reserved. This report is for informational purposes only, and does not constitute investment advice or an offer to sell or the solicitation of an offer to buy any security of any entity in any jurisdiction. No guarantee is made that the information in this report is accurate or complete and no warranties are made with regard to the results to be obtained from its use. In addition, Lipper will not be liable for any loss or damage resulting from information obtained from Lipper or any of its affiliates. For immediate assistance, feel free to contact Lipper Client Services toll-free at or via at For more information about Lipper, please visit our website at
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