Active equity management: The next wave in ETFs

With their low costs, intraday trading and potential for tax efficiencies, ETFs have made their way into nearly every corner of investor portfolios, with one notable exception – actively managed equity strategies. But that’s likely to change soon.

Recent regulatory rulings have laid the groundwork for active managers to start offering strategies once available only through mutual funds. Unlike passive ETFs designed to closely mirror market indices, active funds pursue other objectives by using research to identify those stocks considered most attractive.

Not just for bond ETFs anymore

Access to active equity platforms would be a welcome development for investors who prefer the ETF wrapper but not necessarily indexing. Until now, their active ETF choices have been mostly limited to fixed income strategies. In fact, according to ETF.com, active equity ETFs account for just 0.3% of total U.S. ETF assets, as managers remain reluctant to extend their offerings outside the mutual fund space.

The sticking point has been transparency. While mutual funds are required to publish their full portfolio holdings only once per quarter, most ETFs must do so every day. For many active managers, daily transparency raises red flags about revealing the “secret sauce” inside their portfolios or having that intellectual property misused by unethical traders.

Meet “semi-transparent” active equity ETFs

In response to manager concerns, the Securities and Exchange Commission has approved the industry’s first semi-transparent, actively managed ETF structures. The move is expected to usher in a wave of new equity ETFs that are required to disclose holdings less often than daily, but at least quarterly.

Semi-transparent ETFs will use different methods to protect the identity of their stock picks, while still providing enough information for shares to be accurately priced and efficiently traded throughout the day. From an investor’s perspective, most changes will occur behind the scenes. The process of buying, holding and selling shares will be the same, whether it’s semi-transparent ETFs or their traditional, fully transparent siblings (click here for more details).

What to look for in an active ETF

When evaluating active equity strategies, you’ll want to consider many of the same factors as any other ETF – investment objective, issuer and cost, to name just a few. Be sure, however, to also account for variables unique to active management, including:

• Select an ETF manager that you value: When evaluating potential active ETFs, investors should consider the character and capabilities of the ETF manager. Investors should choose to invest with a manager they value, and that has history of delivering investment expertise and insights.
  
  
• Understand the ETF investment engine: While active strategies strive to deliver potential excess returns over and above the benchmark return, the range of possible outcomes and performance deviations from traditional benchmarks will be much greater than with market cap ETFs. It’s important to understand their mechanisms for selecting stocks, constructing portfolios and managing risk.
  
  
• Look at the liquidity of underlying securities: A good active ETF will maintain exposure to liquid and tradeable underlying stocks that enable the issuer to handle large inflows or outflows without major disruptions to the share price.
  
  
• Focus on trading expertise: Before placing trades, you may find it helpful to contact the ETF issuer directly. At the J.P. Morgan Capital Markets Desk (844-CAP-MKTS or 844-227-6587), we maintain a keen eye on the market at all times and have proprietary trading models that can assist with understanding the costs involved in execution. Our strong relationships with market makers and APs, as well as our major presence in the marketplace, help deliver the trading expertise many investors seek.
  

Playing many roles in diversified portfolios

Active equity ETF uses range from long-term strategic core holdings, to complementary pieces, to shorter-term tactical allocations. Investors might own them to pursue specific outcomes, such as outperforming a passive index, generating income or reducing risk. As diversification tools, they can round out existing holdings, fill gaps or provide exposure to asset classes not easily replicated with passive approaches.

Finally, active ETFs bring more flexibility to passive-centric portfolios. In periods of uncertainty, for example, managers can take defensive measures aimed at reducing volatility and limiting losses versus a benchmark.

Risk summary: The prices of equity securities are sensitive to a wide range of factors, from economic to company-specific news, and can fluctuate rapidly and unpredictably, causing an investment to decrease in value. International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations.

Opinions and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors.

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