FMD Capital Management

Why Your Menu Of Active ETFs Is About To Get Even Better

Written by David Fabian, January 30th, 2014

The world of ETFs is expanding on an almost daily basis as investors realize the benefits of these low-cost, diversified, and easy to use investment vehicles.  The first decade of ETF issuance was primarily marked by passive strategies designed to track a specific index with transparency and liquidity.  However, recently we are seeing more active products introduced that offer the managers’ flexibility to choose their portfolios with discretion through their own research and fundamental outlook.

The launching of actively managed equity and fixed-income ETF strategies has been met with mixed reviews.  Some products immediately garner assets and sustain momentum on the back of their managers’ expertise, track record, and marketing savvy.  Others languish in relative obscurity when investors compare their high fees, mediocre returns, and complicated trading strategies.   Often times investors have a hard time distinguishing how the manager is adding value in relation to a benchmark and how the fund will react to specific opportunities or risks.

One of the most successful launches of an actively managed ETF was the PIMCO Total Return Fund (BOND) which leveraged the reputation and achievement of its mutual fund counterpart into a cheaper and more flexible variant.  This fund has garnered over $3.5 billion in total assets and despite the headwind of rising interest rates in 2013, has been able to capture a loyal base of investors who believe in the manager’s expertise.

This month, PIMCO followed up the success of its flagship ETF with two additional actively managed strategies that focus on short duration and global bond portfolios.  The PIMCO Low Duration ETF (LDUR) and PIMCO Diversified Income ETF (DI) both replicate existing mutual fund strategies.  In addition, PIMCO has filed to launch as many as 19 additional active ETFs that will leverage the track record and notoriety of both proprietary fixed-income and equity portfolios.

The largest hill that these new ETFs will have to climb is garnering investor assets in a space that is crowded by low-cost competitors and passive indexes.  The newly launched LDUR for instance has an expense ratio of 0.55% and seeks to invest in high quality, short duration bonds across the mortgage, treasury, and corporate bond spectrum.  However, it will face stiff competition from the likes of the Vanguard Short Term Bond ETF (BSV) which charges an expense ratio of just 0.10%, has assets of $13.9 billion, and has been in existence since 2007.

The marginal alpha that LDUR could potentially add over a fund like BSV may be quickly eaten up by its higher expense ratio.  In addition, with short term interest rates at such depressed levels, it may be hard for an active manager to maneuver in this jam-packed space.  More than likely the primary reason for choosing a fund such as LDUR will be name recognition and brand loyalty to a company like PIMCO that has been a staple in retirement portfolios for decades.

In addition, it will be interesting to note how some of the PIMCO equity strategies are received in comparison to their core base of bond investors.  These stock picking portfolios will have to employ a clear message of how they are implementing their tactics in order to take assets away from established ETFs with long-term track records.

In my opinion, the more exciting opportunity is the pending filing of an ETF that replicates a non-traditional bond strategy such as the PIMCO Income Fund (PONDX).  While a launch date has not been set yet, this ETF would likely do quite well in its current format as a portfolio that can go anywhere and do anything.

The manager, Dan Ivascyn, did a fantastic job of managing interest rate risk in 2013 and taking advantage of opportunities (both inside and outside the U.S.) in a multitude of bond sectors.  This led to 2013 returns of better than 4.5%, an effective duration of less than 5 years, and a current 30-day SEC yield of nearly 4%.  According to my research, there is not an ETF that has the same flexibility and risk management capability that this strategy provides.

ETF investors will benefit from the transparency that regulates these entities as well.  Unlike open-ended mutual funds which typically post their holdings quarterly, active ETFs are required to post their holdings on a daily basis.  This information can usually be found via the fund company’s website and provides a clear picture of the strategy that is being implemented at any given time.   That way you know exactly how the portfolio is structured and how they are implementing changes.

At the end of the day, the debate over active and passive management will continue to rage over the differences between higher fees, total return, and managing specific risks.  There are going to be periods of time when the passive index outperforms and vice versa.  However, it is up to each individual investor to be able to identify with the manager of a fund and understand the pros and cons of each method.

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