Getting Active in 2018

MarketsETF Trends

By Grant Engelbart, CLS Investments

Some of the most common New Year’s resolutions are to work out more, lose a few pounds, or just be more active in general. Despite the overwhelming trend in flows into low-cost, passive, index investment products, investors would be wise to adopt the same resolutions with their investments.

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Actively managed mutual funds have been around for nearly a century and still command more than $11 trillion in assets (in the U.S.) However, over the past three years, more than $400 billion has flowed out of active mutual funds, mainly into passive ETFs. There have been many reasons cited for this migration, with the most common being higher costs and underperformance of active managers. But do active managers add value? The answer might surprise you.

Since 2001, using Morningstar categories as a proxy, active managers on average have delivered negative excess returns relative to applicable benchmarks. Some categories did outperform (high-and low-category returns shown in the boxes below), but on average, active managers failed to add value above and beyond their expenses.

Those expenses are a key reason for the underperformance. Looking at the current category-level expense ratios (gold boxes below), it’s clear that expenses have eaten away most of the excess returns. Given expenses have undoubtedly come down over time, this likely understates the impact. With these data points, we can create estimated gross returns for active managers over this time period (teal boxes). It turns out – without the effect of fees, active managers can add some value! Who would have thought?

While I hope this seems reasonable to most, looking at flows and the trend of product launches, and maybe some regulatory influence, it seems many are scoffing at active management. However, if active managers in aggregate can add some (gross) value, and there are undoubtedly many high-quality managers who are adding value regardless, simply reducing the overall costs of active management could have a significant impact.

Enter ETFs. If you are on reading this on ETFTrends.com, I would hope ETFs aren’t all that new to you. But actively managed ETFs are a more recent phenomenon (particularly on the equity side). If we could transport a few high-quality active managers to the lower-expense and more tax-efficient ETF wrapper, that would be a win-win for just about everyone.

Luckily, we are starting to see that. 2017 was the best year yet for active ETF launches and flows. But, even after a great year, active ETFs still make up a measly 1% of total ETF assets! The runway is long, and it’s a great opportunity for active managers to reintroduce their management styles and strategies to a newer audience.

Within fixed income ETFs, active managers have been prevalent and successful. Front-running and transparency issues are seemingly of less importance, and some of the best and largest names in active management have entered the fold. Within equities, the adoption has been slower, particularly as active managers wait for regulatory answers to non-transparent active ETFs structures. However, we have seen high-profile managers enter, or at least file for entry into, the active transparent space.

2018 certainly may require more active navigation than 2017, which was as smooth a market as we have seen in decades. Rising interest rates, elevated valuations, dropping correlations, and other factors could all bode well for active managers to outperform in the coming years.

So, get out there, and get active! Investors may find active managers do add value and the old adage is true: you get what you pay for.

Grant Engelbart, CFA, CAIA, is a Portfolio Manager at CLS Investments, a participant in the ETF Strategist Channel.

This information is prepared for general information only.  Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such.  All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only.  No graph or chart should be regarded as a guide to investing.

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