Active ETFs bring new strategies and price competition

The mutual fund and ETF industries are starting to look more like one another. And it's not only because of the expansion into exchange-traded funds by mutual-fund stalwarts such as three major banks, Mackenzie and CI, and other upcoming entrants such as AGF. Another aspect of convergence is the growing number of fully active ETF mandates, which not only deviate from benchmark indexes but also operate without any specific quantitative constraints.

The newest fully active arrivals include Canadian equity and U.S. equity ETFs launched on Sept. 23 by First Asset Investment Management and managed by its affiliate Cambridge Global Asset Management. Also last week, RBC Global Asset Management launched RBC Canadian Preferred Share (RPF), its first actively managed ETF .

These three new ETFs join more than 50 others already on the market. Horizons ETFs Management has the most extensive line-up, with 28 active ETFs and a combined total of $3 billion in assets. The other ETF firms that currently have numerous mandates in this segment of the market are First Asset and BMO Asset Management.

Actively managed ETFs represent the greatest encroachment yet on to what has historically been mutual-fund turf. And while market-cap-based indexing is still the dominant ETF approach, led by the iShares family of funds and its 49% share of the Canadian-listed market, most of the future product expansion will be on the more active side of the business. After all, how many competing S&P/TSX Composite or S&P 500 index products does an investor need to choose from?

ETF alternatives to passive indexing have come mostly in the form of strategic-beta mandates. Though these are a form of active management, they borrow some techniques from passive indexing, in that strategic-beta stock picks are made on the basis of rules-based quantitative criteria. Examples of firms that specialize in strategic-beta strategies include the self-described "intelligent indexing" employed by various PowerShares ETFs, as well as newer ETF providers such as First Trust, Purpose Investments, Sphere Investment Management and WisdomTree Investments, the latter expanding into Canada from its U.S. base. Nearly all other Canadian ETF providers have strategic-beta ETFs as part of their line-ups.

Fully active mandates have resulted in even greater differentiation among ETF providers in terms of strategies, risk-return profiles, fees and performance. Investors should consider the merits of this non-traditional breed of ETFs, while keeping in mind the following:

Active ETFs may perform either better or worse than market benchmarks

Even if they outperform, they're not immune from unfavourable market trends. For example, Horizons Active Preferred Share ( HPR ), which like others in its peer group has been hit by low-yielding rate resets of its holdings, has a scant five-year return of 0.7% to Aug. 31. But its passively managed rival, iShares S&P/TSX Canadian Preferred Share Index ( CPD ), fared even worse, losing an annualized 1.2% over the same period.

Active management may be only one element of an active ETF's strategy

This can be particularly true for funds that employ covered-call strategies. Covered calls are options that the fund manager sells against stocks that the portfolio holds, in order to generate tax-advantaged premium income. While covered-call writing is actively managed, the equity holdings may be rules-based or match an index. BMO Covered Call Dow Jones Industrial Average Hedged to CAD ( ZWA ) is a prime example of how active options writing can be combined with passive stock selection.

Actively managed ETFs cost more than their index counterparts

For instance, in the Canadian Dividend Income Equity category, the management-expense ratio (MER) of the common units of First Asset Active Canadian Dividend ( FDV ) is 1.01%. By comparison, the MER of the passively managed Vanguard FTSE Canadian High Dividend Yield Index ( VDY ) is only 0.22%, a meaningful cost advantage in the current low-yield, low-return environment.

Active ETFs may be cheaper than comparable mutual funds

The newly launched First Asset Cambridge Core U.S. Equity (FCY) charges a management fee of 0.7%. Compare this with the 1% management fee for the fee-based series of CI Cambridge American Equity Corporate Class, which pays no advisor compensation, and 2% for the Class A shares, which are sold through commissioned brokers and dealers and pay trailer commissions. So while active ETFs cost more than passive ETFs, they're bringing a new element of price competition to the investment-fund industry as a whole.