The Faltering Case for Active ETFs | Chief Investment Officer

Investors overwhelmingly prefer passive exchange-traded funds (ETFs) to their active counterparts, a survey has shown, despite many asset managers latching on to this new option.

Just 6% of respondents to EDHEC-Risk Institute’s annual survey—conducted with Amundi Asset Management—said they preferred active ETFs to passive vehicles. In contrast, 70% preferred passive vehicles with just 22% having no preference.

ETF active 1 The lack of enthusiasm for these new products may be caused by a dilemma that is inherent to their nature, the survey said.

“Active ETFs are supposed to have some of the advantages of ETFs, such as transparency, tax efficiency, and liquidity, all while being actively managed,” the report stated. “However, since managers are paid for their stock selection, frequent disclosure of the underlying stock holdings would encourage other investors to buy the underlying securities on their own instead of trading ETFs. On the other hand, if transparency is low, the price of ETFs would suffer significant deviation from the net asset value of the underlying holdings.”

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EDHEC said many ETF providers in the US had made applications to the Securities and Exchange Commission to launch actively managed ETFs that would not disclose their holdings on a daily basis, but have not been permitted to do so by the regulator.

“This may illustrate the conflict between the product providers’ desire to keep their investment strategies private when it comes to active management and the regulators’ efforts to maintain the key property of transparency within ETFs,” the institute said.

Despite the efforts from some fund groups intent on launching new actively managed products, the percentage of investors showing a preference for them has remained the same, the survey showed.

PIMCO launched the Total Return Active ETF in March 2012 and within eight months it was the largest product of its kind, with $3.4 billion in assets. However, compared to the traditional fund it was set up to mirror, it has less than 3% of the assets.

“Innovations of ETFs should catch up with the innovations of indices.” —EDHEC Risk Institute“Actively managed ETFs are indeed not as important to our respondents and only 16% think that ETFs should shift from passive to active,” the survey concluded. “This percentage is quite stable through the years (18% in 2013, 17% in 2012).”

There is one area where asset managers should instead be looking, the survey suggested.

“We can also see that 38% of respondents find it important for ETFs to track niche markets,” it said. “In other words, innovations of ETFs should catch up with the innovations of indices.”

At the top of investors’ agendas for these niche products were emerging markets and smart beta ETFs.

New research into the spread of Ponzi scheme frauds has suggested several social factors that lead to poor investment decisions.

Ville Rantala, of the Aalto University School of Business in Helsinki, Finland, looked into the spread of the WinCapita Ponzi scheme, which grew in Finland between 2003 and 2008, in his paper “How Do Investment Ideas Spread through Social Interaction? Evidence from a Ponzi Scheme”.

“A few powerful individuals with many social connections can significantly facilitate the epidemic spreading of contagious ideas.”He found evidence that older, wealthier investors are more likely to influence more people to join, and suggested that investors prefer to assess their trust in the person recommending an investment, rather than the investment itself.

“The findings suggest that social network structures play an important role in the spreading of investment ideas,” Rantala wrote, “and few powerful individuals with many social connections can significantly facilitate the epidemic spreading of contagious ideas.”

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Likening the growth of Ponzi schemes to the spread of diseases, Rantala explained that any investor with a large social network was both more likely to be roped in, and more likely to pass a recommendation on to others.

“Although investors’ social learning can produce welfare-improving outcomes in many situations—e.g. through higher stock market participation and better portfolio diversification—the evidence of this paper indicates that it can also spread and exacerbate investment mistakes,” Rantala said.

The author also suggested that investors could make themselves susceptible to poor decisions by “question substitution”.

“In the case of Wincapita, some investors may have exchanged the more complex question ‘Do I trust this investment scheme?’ to the simpler question ‘Do I trust the person who is telling me about this investment scheme?’” Rantala said.

WinCapita was set up by Hannu Kailajärvi in 2003, purporting to make profits from sports betting and, latterly, currency trading. The scheme had €100 million of investors’ cash on its books when it was shut down in 2008. Rantala said 10,000 people invested in total, roughly 0.2% of Finland’s population.

The full research paper is available for download here.

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