Chapter 18
Going Active with ETFs
IN THIS CHAPTER
Appreciating the difference between passive and active investing
Weighing the pros and the cons of actively managed ETFs
Reckoning how active investing might play into your life
Choosing from a smorgasbord of fund options
The first ETF in the U.S. was launched in 1993. It was the S&P 500 fund SPY. It was an index fund. And for the next 15 years, all ETFs were index funds. But then, in 2008, years of wheedling the SEC paid off, and Wall Street was finally allowed to issue its first actively managed ETF.
It was foreshadowing, and ironic, that the very first actively managed ETF was issued by Bear Stearns. Within several months, the financial collapse of the investment banking industry, led by Bear Stearns, was well on its way to creating the worst bear market (more irony) of our lifetimes. That first ETF died, folding (with money returned to investors) in October 2008, as Bear Stearns, after 85 years in business, collapsed and itself folded.
Since that time, I’ve seen the opening (and the closing) of dozens upon dozens of actively managed ETFs. At present, there are about 650 actively managed ETFs. That’s nearly one-quarter of the ETF universe. But those active funds have failed to accumulate a whole lot in assets. According to Morningstar Direct, those 650 or so funds hold less than four percent of all investors’ money stored in ETFs.
Not Exactly Setting the World on Fire
Why have active ETFs in the aggregate been such duds? I have a few hypotheses:
- Most ETF buyers are indexers by nature. They know that index funds, as a group, do much better over time than actively managed funds. I’ll throw out a few numbers later in this chapter. (You can also read more about this topic in Chapter 1, or for more detailed information, see my book, Index Investing for Dummies, also published by Wiley.) The bottom line, if I may steal a line from Obi-Wan Kenobi, is that most ETF buyers know that if they stick with index funds, The Force will be with them and not with those who choose active management.
- Most ETF buyers want transparency. Active managers, reluctant to reveal their “secret sauce,” have not been too keen to comply with the transparency rules of ETFs, and they’ve been lobbying government officials to change those rules. Finally, in 2019, the SEC caved…a bit. Active ETFs can now have their secret sauce, and they can change the recipe day to day, but they must reveal it to shareholders either monthly or quarterly with a lag of up to 60 days. Note that this is in contrast to the passive ETFs that must disclose their complete holdings every morning before Wall Street’s opening bell. Ding.
- Many of the active funds are just plain goofy. Many actively managed funds are highly speculative and not the kinds of investments into which smarter investors (as most ETF investors tend to be) are going to plunk their money. In 2019 and 2020, there were more ETF closings than openings, and many of them were actively managed. And goofy. Among the dead: Sit Rising Rate ETF (SIT), EventShares U.S. Legislative Opportunities ETF (PLCY), James Purpose Based Investment ETF (JPBI), and ProSports Sponsors ETF (FANZ). Among the brand-spanking new: Simplify Volt Pop Culture Disruption ETF (VPOP) and Merlyn.AI SectorSurfer Momentum ETF (DUDE).
A number of the active funds have been issued by relatively unknown and not terribly well-funded companies. Just look at some of the names you see in the preceding bullet. Add to the list the now-defunct Dent Tactical ETF (DENT), based on the strategies of best-selling author and crystal-ball gazer Harry S. Dent, which entered the market in the summer of 2010, provided investors with three years of dismal performance, and then shut its doors.
Oh, and did I mention that the DENT ETF charged 1.5 percent a year in management expenses, which, among ETFs, is sort of the equivalent of a $480 pair of jeans? The other actively managed ETFs aren’t cheap, either. And that’s part of their problem. A big part. By the way, Harry Dent is still a regular on financial news shows — always happy to pull out his crystal ball. Happy Harry.
Do You Want to Get Active?
You may have already surmised that I’m not a big fan of active investing, but I don’t want to give you the wrong impression. Not all active funds are silly or overly expensive. Some may very well make sense in your portfolio.
But remember that The Force is not with you. Sure, every active manager has a great story. But when you look at all the actively managed fund managers who’ve told great stories for years, very few of them do better picking stocks (or bonds) than a monkey throwing darts at a dartboard could do. Care to guess how many actively managed U.S. large-cap growth funds have outperformed the indexes in the past 10 years? Only about 9 percent of them, according to Morningstar Direct. Small-cap value stock funds? About 29 percent have beaten the indexes. Foreign large-blend funds? About 20 percent. Intermediate core bond funds? About 28 percent have beaten the indexes over the past 10 years, but that drops to less than 10 percent outperforming over the past 20 years.
As I said, not good odds. But if you are going to go with active management, active ETFs can be less expensive and more tax efficient than their corresponding mutual funds. That offers reason for hope. On the flip side, active ETFs have a big disadvantage in that they can’t, like a mutual fund, close the fund to new investors. As a result, actively managed ETFs can get bloated. The manager may be forced to take on new holdings or increase positions they don’t really want to increase.
On balance, you must keep in mind that historically, actively managed funds as a group have not done nearly as well as index funds. (Trust me, the Morningstar research I cited earlier is from a very large body of research done by any number of firms or academic institutions.) That being said, active management may sometimes have an edge, especially in some areas of the investment world, such as micro caps, a universe too small to have been well studied, or commodities. And much of the advantage of index investing has been in its ultra-low costs — something that actively managed ETFs could possibly emulate. Investors will see over time if active management improves its track record.
Let’s Get Practical
If you want to go with an actively managed fund, I ask you to at least keep in mind the lessons learned from indexing and what has made indexing so effective over time. Basically, you want certain index-like qualities in any actively managed fund you pick:
- Choose a fund with low costs. With so many ETFs allowing you to tap into stocks or bonds for a fraction of a percentage point a year, you do not need or want any fund that charges much more. Any stock fund that charges more than, oh, 0.60 percent, or any bond fund that charges more than about 0.30 percent, is asking too much, and the odds that such a fund will outperform in the long run are very slim. You should probably go elsewhere.
- Watch your style. Make sure that any fund you choose fits into your overall portfolio. Studies show that index funds tend to do better than active funds in both large caps and small caps, but in small caps, you have a better chance that your active fund will beat the indexes. That’s because large caps are more thoroughly scrutinized by investors, so finding a company with hidden strengths would be like finding a $50 bill on the sidewalk at 42nd and Broadway.
- Check the manager’s track record — carefully. Make sure that the track record you’re buying is long term. (Any fool can beat the S&P 500 in a year. Doing so for ten years is immensely more difficult.) I’d look at performance in both bull and bear markets, but your emphasis should be on average annual returns over time compared with the performance of the fund’s most representative market index over the same period. And remember that a fund’s returns will be determined largely by its asset class. In other words, a small-cap value fund should outperform the S&P 500 over time because it is riskier, and risk equals return, generally. The more important question is whether that small-value fund has beaten the small-value indexes over time.
- Don’t go overboard with active management. Studies show so conclusively that index investing kicks butt, that I would be very hesitant to build anything but a largely indexed portfolio, using the low-cost indexed ETFs that I suggest throughout this book.
A Look at Some of the Most Popular Actively Managed ETFs
Not all active ETFs have struggled for assets. Some have done very well in terms of getting new investors on board. Let’s take a glance at some of these apparently better mousetraps — why they are popular and what may make them special.
As I’m something of a skeptic when it comes to active management, I’m not going to be outright advocating that you buy any of these funds. Nor am I going to trash any of them. The following funds are probably among the active funds that I would advocate, if I were to advocate any. The active funds that I would trash, if I were to trash any, are presented in Chapter 20.
ARK Innovation ETF (ARKK)
By far, the most popular active ETF, ARKK is managed by Cathie Wood, who has arguably become the most well-known fund-manager superstar since Fidelity Magellan Fund’s Peter Lynch. Founded in 2014, ARKK invests in what Wood calls “disruptive technology” — technology that “changes the way the world works.” The fund is currently invested in Tesla (12 percent of the portfolio); Teladoc Health; Roku, Inc.; Square, Inc.; Zoom Video Communications; and other high (and “disruptive”) technology, and it has seen phenomenal returns: 34.3 percent a year since inception. And, by the way, if imitation is the best form of flattery, I’m noticing that practically all new ETFs on the market are claiming to be “disruptive.” The word is quickly becoming as hackneyed as the word literally is among millennials.
Wood, interestingly enough, is almost the opposite of Peter Lynch. Lynch was well known to be wary of new technology. In fact, when he retired in 1990, after 13 years commanding the Magellan Fund, it was just at the dawn of the dot-com revolution that led to one of history’s greatest bull markets (1991 to 2002). Lynch, had he not retired, undoubtedly would have missed out, and his legacy would’ve turned to mud. Will the same happen to Cathie Wood? The companies she’s selected have been enormously successful, but their stocks’ valuations are now in nosebleed territory. And the fund, now with more than $25.5 billion invested, is not going to be as nimble moving forward. In order for this fund to continue overperforming (and to overcome the 0.75 percent management fee that creates considerable drag for investors), its holdings will have to grow like wildfire. That may occur. It may not.
At least one company, called Tuttle Capital Management, LLC, has filed with the SEC to issue an ETF that would trade under the ticker SARK, and it would short (bet against) Cathie Woods’ ARKK. (Perhaps SNARK would be a better ticker?!) Interestingly, SARK is planning to charge the same as Wood: 0.75 percent a year. In other words, whether Wood’s future picks are winners or losers, whether investors win or lose, the house — or more accurately, two houses — will be making good money.
JPMorgan Ultra-Short Income ETF (JPST)
With interest rates on bonds so low, and with the general sentiment being that interest rates are likely to climb, ultra-short bonds have been extremely popular, even though they’ve been paying squat. This fund, with 773 very short-duration bonds, mostly investment-grade corporate bonds, has managed to eke out a return of about 1 percent over the past year. Most ultra-short bonds have earned far less. Is it because JPMorgan is taking some credit risk that other funds aren’t? Or do the company managers really provide return above and beyond? Time will tell. In the meantime, the expense ratio of 0.18 percent is reasonable, and given this reasonable expense ratio, and JPMorgan’s experience, you haven’t all that much to lose if you want to employ this fund, rather than an index fund, for tapping this asset class.
PIMCO Enhanced Short Maturity Active ETF (MINT)
PIMCO has been in the active-management-of-bonds business for many years, and the company was among the first to issue actively managed bond funds. Like JPST, MINT offers ultra-short bonds — largely corporate, but with some government bonds, as well — and a healthy serving of international bonds. The return has been less than JPST’s (0.71 percent versus 0.97 percent). However, the lower return is in part due to the safer bond mix. But also, the expense ratio is higher — 0.35 percent — and that will eat into any returns you get. I’d be more inclined to buy this fund — or any other bond fund that charges more than the cheapest index funds — if interest rates were to climb.
Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL)
A unique fund, IVOL bills itself as a hedge fund, in the original sense of the word. (The term hedge fund is now often used to describe any private investment partnership; originally, it meant a fund that offered investments with little to no correlation to the broad market.) IVOL, in fact, has shown very little correlation to either the stock or the bond market since its birth in May 2019. And it has done this while providing an impressive return of 8.5 percent annually. It does this with a portfolio that is 85 percent U.S. inflation-protected Treasuries and the rest in options that seek to increase in value when volatility of other asset classes rises. Quadratic Capital, which runs this fund, is owned by Krane Fund Advisors, LLC, which is in turn majority-owned by China International Capital Corporation, one of the largest investment banking firms in China. The fund charges 0.99 percent, which is awfully expensive. But there aren’t many investments out there that can serve as effective hedges to both stocks and bonds.
First Trust Long/Short Equity ETF (FTLS)
Going “long/short” is an ages-old hedging technique of active managers, whereby the fund holds both long positions (stocks you expect to go up) and short positions (stocks you expect to go down). So, yes, it is all about stock picking. Why go both long and short? Because your other stock funds, passive or active, will tend to go up when the stock market as a whole is going up, and they will tend to go down when the whole stock market is going down. Long/short funds take bets in both directions to temper volatility. In the case of FTLS, 80 to 100 percent of the positions are long. Zero to 50 percent are short. So the fund will tend to go up in good times, and down in bad times, but probably not as much (in either direction) as your other stock funds. The fund charges 0.95 percent in management fees, but there are additional fees incurred in shorting, bringing the total annual expenses to 1.55 percent. This is high, but actually not outrageous for this kind of fund. So far, the fund, founded in 2014, has done well, with a return since inception of 8.1 percent versus the S&P 500’s 14.1 percent.
KraneShares Global Carbon ETF (KRBN)
This fund might be considered an actively managed commodity fund, but it is, in one sense, very different than other commodity funds: The commodity is not gold or silver or copper or corn. It is something entirely intangible. The fund buys up futures on cap-and-trade carbon allowances, which governments in Europe and North America require industries to have in hand before emitting greenhouse gases into the environment. The thinking is that as global climate change worsens, governments will tighten carbon emissions, and the prices of these allowances will rise. Meanwhile, the more investors there are clamoring to own the allowances, the more the forces of supply and demand may force the prices up on their own, which, incidentally, would be good for the planet as it would serve as an incentive for industry to pollute less. (Silver prices shot up when investors started to pour money into silver ETFs; carbon allowances could follow in silver’s path.) The fund was formed in July 2020, charges 0.79 percent, and in its first year, returned 76.4 percent.
Author’s disclosure: I bought a modest position in this fund for my own account, and I’ve started to discuss it with clients who have a high tolerance for risk. What’s the risk? As I see it, a major breakthrough in manufacturing technology could, in one fell swoop, end the global climate crisis and kill the market for carbon allowances. If that happens, I would be thrilled to have lost money!
Time to Swap Out Your Active Mutual Funds?
If you happen to be invested in a popular, actively run mutual fund, such as the T. Rowe Price Blue Chip Growth Fund (TRBCX), and you like and trust the fund’s management and want to stick with them, you now have the option of moving your money. In the case of T. Rowe Price Group, Inc., you can move it from TRBCX to the T. Rowe Price Blue Chip Growth ETF (TCHP), introduced in August 2020. Should you? After all, the fund manager is the same, and the fund’s strategy is the same. The only significant difference is the wrapper, and the mutual-fund wrapper is more expensive than the ETF wrapper, as is typically the case. TRBCX charges 0.68 percent, whereas TCHP charges 0.57 percent.
In addition, the ETF wrapper will almost always offer great tax efficiency. And, as opposed to the mutual fund, it will never have a minimum investment. You want one share? You got it.
Yes, you should consider switching. Be aware, however, that if you hold your mutual fund in a non-retirement account, this may result in a capital gains tax hit. Find out before you make any moves. Vanguard mutual funds can be transferred to their ETF equivalents without tax ramifications, but that isn’t the case with other fund companies. Vanguard is currently the only firm offering ETFs that are a distinct share class of their mutual funds.
Note: Other fund companies, however, may decide to turn a mutual fund you hold into an ETF. If that is the case — rather than your deciding to switch — there will likely be no tax ramifications to you.
Transferring from mutual fund to ETF is actually a win-win for both investors and the fund companies, as ETFs are far easier for fund companies to administer than mutual funds.
T. Rowe Price is but one of many primarily active mutual-fund companies that are now issuing ETFs, often at a significantly lower price than their similar mutual funds. PIMCO is another. Fidelity is a third. Franklin Templeton is a fourth. There’s also American Century, Putnam, Dimensional, Goldman Sachs, Legg Mason, John Hancock, and JPMorgan. If you have mutual funds with any of these companies, I suggest you go to their websites or talk to a rep to find out if ETF alternatives exist or are in the pipeline.