Active ETFs: Europe has a way to go

As Europe is yet to see the significant uptake in actively managed ETFs that the US market has experienced, Annabel Smith asks why that is and how active ETFs operate.

Global markets have seen a steady uptake in the number of exchange traded funds (ETFs) in the last eight years.

They, among other index tracking investment vehicles, have become popular in this increasingly passive era, as the market continues to question whether active investment can outperform passive strategies that, in some cases, cost investors half as much in fees.

Similar to a mutual fund in that they typically track an index, ETFs differ from other passive instruments as they allow a basket of stocks to be traded in one transaction on an exchange. Unlike mutual funds, ETFs also offer intra-day access to liquidity. This can minimise risk and transaction costs, while allowing traders to gain price discovery with low information leakage.

In Europe alone over the last eight years, ETFs have grown at an annualised rate of 20% in terms of assets under management (AUM) with over $1 trillion of notional now held in European listed ETFs.

Chief among the reasons behind the steady uptake in ETFs is the continuous compression of margins in the asset management industry as investors increasingly expect more for their money and favour cheaper products.

Jason Xavier, head of EMEA ETF capital markets at asset manager and ETF issuer, Franklin Templeton, says the global pandemic is another reason that the market’s uptake in ETFs has accelerated.

“If you look at the volatility we saw last March at the outset of the COVID-19 pandemic, the subsequent successful operation of ETFs and the ETF ecosystem in allowing investors to source liquidity and reallocate capital intra-day was, for some, the final success hurdle needed to validate the ETF wrapper,” he explains.

Pushing boundaries

As the market has continued on its trajectory towards cheaper investment strategies in a riskier pandemic-driven environment, a new type of active ETF has been born. At face value, active ETFs tick all the boxes by offering risk averse investors who are looking to cut costs access to a version of active investment.

According to Howie Li, head of ETFs at asset manager and ETF issuer Legal & General Investment Management, active ETFs fall into two categories. These include thematic ETFs which are based on underlying stocks that have been selected through research, and discretionary active ETFs that have a fund manager making buying and selling decisions.

“Certainly, in the last three or four years the boundaries continue to be pushed as to what should be defined as an ETF and what is classified as an active strategy,” says Li.

“What we have done is active design, we select stocks that are specific to the cyber security universe, or robotic universe, because these are all opportunities that are not traditionally defined. We built these investment strategies in a way that is very similar from a client’s point of view to the active experience.”

This form of thematic ETF stock picking derives from the market’s journey away from how investors think about asset allocation. Previously, asset allocation for ETFs was based on regional indexes, however, as the market has become increasingly globalised this method has become sub-optimal.

Wholly active ETFs that have a fund manager responsible for buying and selling have also seen an astronomical spike in interest. However, the interest is predominantly limited to the US. Founder, CEO and chief investment officer at ARK Investment, Cathie Wood, for example, has taken the market by a storm recently with 152.2% returns on her actively managed ETF funds in 2020.

According to a recent report by FactSet, 2020 was the first year that there were more active ETFs launched in the US than passive ETFs that track an index, with actively managed ETF funds bringing in a total of $56.1 billion over the period.

On 26 March, Guinness Atkinson Asset Management became the first investment firm to convert two mutual funds with assets of $21 million to actively managed ETFs. US investment bank Citi also confirmed plans to work with Dimensional Fund Advisors to switch six mutual funds, with total assets of $20 billion, to the active ETF wrapper in 2021.

Despite the active portion of the market only making up 3% of the $8 trillion total value of the ETF industry, these moves could represent turning tides as the mutual fund market and its lack of intra-day liquidity becomes more and more outdated.

Final hurdle

The US market is undeniably leaps and bounds ahead of Europe in its uptake of more actively managed ETFs. This is largely due to the Security and Exchanges Commission’s (SEC) recent relaxation of its regulation in 2019 that allowed for more discretion in ETFs.

The SEC recently introduced new regulations that allow for discretion when disclosing which stocks are within an ETF wrapper, meaning ETFs no longer have to make public their holdings on a daily basis.

With one of the foundation pillars of ETFs being transparency, prior to this change in regulation they were not favoured by active fund managers. Many view their stock picking abilities as intellectual property and therefore do not wish to disclose the information.

“There are active ETFs in Europe of course, but they’re still required to disclose their portfolio holdings on a daily basis. It limits the number of products that these issuers are looking to launch because they’re not necessarily comfortable with having that openness and transparency around their active trading strategies,” says Steve Palmer, global head of ETF products at HSBC Securities Services.

“If we got to a position where the wrapper allowed for a similar structure to what the US is comfortable with through the SEC’s positioning of these active products, then I can certainly see that being a trigger point for the European market to start using the ETF wrapper for active products.”

Regulation remains the final hurdle between the European market and the wave of actively managed ETFs that has swept across the US.

“The European market predominantly still expects ETFs to be transparent, but investors are on a journey to understand and see what more ETFs can do as it moves towards the active end,” adds Legal & General Investment Management’s Li.

Diluted liquidity

Whether actively managed ETFs can outperform passive rules-based ETFs and vice versa remains up for debate. However, one clear impact of the rise in active ETFs is the greater variety of choice that investors have.

Li explains that as more active strategies come to market, asset managers that previously did not issue ETFs because they lacked the index capabilities could now do so, meaning the ETF market will continue to grow.

“If more active strategies are launched in an ETF wrapper, it means there is greater potential for investors who prefer active management to look to the ETF market for solutions. This can lead to more volume, which means more possible business for institutional traders,” adds Li.

“Suddenly the mutual fund has been listed on a stock exchange and it’s using the same infrastructure as trading Vodafone. As more of this market builds, there is more available business for traders to try to capture.”

Active ETFs do, however, bring with them an additional layer of risk that passive ETFs do not. For one, there is the additional risk in the judgement of a fund manager to pick and choose when to buy and sell.

“If you go for discretionary management, you are trusting the skill and judgement of that portfolio manager or investment team. If you look back at history, some managers can get it right and some don’t – being consistent through all market cycles has been a challenge,” says Li.

It could also prove difficult to convince market makers of the merits of active ETFs taking centre stage in Europe. Market makers create individual buying and selling markets between issuers and investors, operating on small margins made from each transaction.

It is because of these small margins that they prefer as much transparency as possible. If they know the exact value of an ETF it allows them to trade it more easily.

“Market makers, such as ourselves, need to fully understand the constituents of the basket they are pricing. While this is straightforward in passive ETFs, the constituents of an actively managed ETF are variable, which adds complexity and sometimes lower transparency. As a market marker, our trading desk can only price such instrument when its fully up to speed with what is in it,” says Ron Heydenrijk, European head of sales and external relations at Flow Traders.

“Actively managed ETFs are typically more difficult to hedge, because the further you go away from the general benchmarks the less derivative products you can use to hedge.”

Elsewhere, the fragmented nature of the European market could be slowing the progress of active ETFs, as its various currencies, geographies, settlement depositories and exchanges mean that a significant portion of ETF trades are not conducted on exchange.

“We see a good percentage of [ETF] trades done via multi-lateral trading facilities (MTF) as well as on-exchange, with approximately a 70/30 split between MTFs versus on-exchange activity in Europe,” says Franklin Templeton’s Xavier.

The natural fragmentation of the European market has diluted the liquidity available on exchange and subsequently forced ETF traders to find liquidity off-exchange in the form of request for quote (RFQ) platforms.

“Relative to the US, there is lower on-screen liquidity in Europe. There is, however, significant off-screen liquidity through RFQ platforms, which put market makers in competition with each other, offering institutional investors an efficient way to trade large blocks at attractive spreads,” adds Heydenrijk.

Consolidated tape

Along with diluted on-exchange liquidity, the lack of a consolidated tape in Europe means ETF traders cannot see the volumes taking place off-exchange, in effect blinding them.

“In Europe and the UK, only ETF trades that are traded on-exchange are published and it pretty much ignores 90% of the transactions in Europe, which is pretty crucial. A consolidated tape is essentially going to show both on-exchange and off-exchange, how many deals are happening,” says Li.

“If you want to understand the true liquidity of an ETF and understand how much volume is going through it – investors currently do not have full visibility. They know in the US but they do not know in Europe. The consolidated tape is something that everybody wants.”

While there is no concrete correlation between the number of active ETF launches and a consolidated tape, in offering participants more transparency on the volumes taking place on and off-exchange this could encourage more active strategy-based ETFs to take hold in Europe.

The European Commission recently pushed for the establishment of a consolidated tape in the European primary and secondary bond markets in its upcoming MiFID II review following pressure from market participants. Any concrete action on this is yet to be seen.

Ultimately active ETFs have a way to go before they are welcomed with open arms in Europe in the same way that they have been in the US. However, evidence has shown that they are on the rise and the line between active and passive is continuously moving.

As the face of the ETF continues to evolve, investors will have the opportunity to dip their toes into various pools, picking and choosing tailored investment vehicles that contain a flavour of both active and passive strategies.

“It is a question of how you want to access an active manager’s ideas. If you can use an ETF to perhaps do that, that might be the preferred choice for clients and end-investors,” concludes HSBC’s Palmer.