Portfolio Managers’ Guide to Active ETFs

Access and Liquidity

Let’s hit the low hanging fruit…Unlike mutual funds, hedge funds, or SMAs, ETFs are publicly listed on exchanges (hence the ‘E’) that can be bought and sold by Advisors and investors within qualified broker accounts.  Each brokerage platform may of course have an approval process for each ETF prior to making it available to Advisors and individual investors.  The democratization of these financial products has opened access to a greater number of potential investors by offering increased liquidity and lower minimum investment relative to other wrappers.  The majority of ETFs provide daily disclosure, but some do so at less frequent set intervals.  Transparency regarding an ETFs holdings can provide valuable insight for the most diligent investors.

While the above benefits are viewed as additive for investors with ETF issuers reaching a broader investment base, some managers may still have pause.  Giving up the “Secret Sauce” which active managers use to both deliver alpha and justify higher fees can be a concern.  In addition, managers who utilize less liquid securities in their portfolios may be concerned about front-running during rebalances and may need to find more liquid alternatives that provide similar exposure or risk metrics.

Thoughtful portfolio construction, while not exclusive to ETFs, is a key component to a successful ETF.  A capital markets partner that aids in the process of making an efficient market with a tight spread for your ETF needs to be in your corner – i.e., The Lead Market Maker

Capital Markets Considerations

Lead market makers (LMM) and the capital market community play a critical role in the launch and viability of ETFs.  These firms may specialize in a single or few asset classes, or may cover all, as a LMM for your ETF.  The listing and trading of ETF shares on an exchange is a unique feature relative to other product wrappers.  Capital markets participants not only provide an efficient market on exchange, but they can also help ETF portfolio management teams with the optimization of ETF strategies to ensure an ETF has the best possible liquidity and bid-ask spread.  Many capital markets firms also have affiliated agency brokerage desks to help ETF portfolio managers execute trades and perform custom rebalances to further enhance their relationship with the ETF issuer.

There are an abundance of value-add services capital markets desk can deliver, but the relationship isn’t a one-way street.  Consultation in the portfolio management process often leads active managers to the realization that they may not be able to run the portfolio in the exact way they anticipated, particularly tilting towards more liquid holdings.  High turnover of portfolio holdings also makes it difficult for market makers to effectively hedge their positions of ETF shares held in inventory as they make a market in your ETF – leading to potentially wider bid-ask spreads for the product. 

Among the many benefits a capital markets partner brings to the table, their ability to help facilitate the tax-efficient management of an ETF may take the cake.

Tax Efficiency

The in-kind creation/redemption mechanism is one of the biggest draws for an active manager in their consideration of launching an ETF.  Facilitated by authorized participants (AP’s), ETF managers can exchange ETF holdings with a different or same security.  This in-kind exchange does not result in a taxable event at the portfolio level and is often utilized to diversify overly concentrated positions, exchange holdings that have reached a calculated price target, or even establish a new cost basis. 

If something seems too good to be true, it probably is…The in-kind creation/redemption of securities results in a tax-deferral from the ETF portfolio level to the ETF share price.  Gains from underlying securities in the ETF, and the taxes owed on them, do not just disappear as this is NOT a “tax-dodge”.  When an investor sells their shares of the ETF, resulting in a gain to the investor for example, they will pay tax on the gains associated with the increase in price of the ETF shares.

 The moral of the story – active managers should consider an ETF as a viable option to reach a broader investor base.  While there are many benefits, there are additional ETF specific regulatory requirements and capital markets implications to consider.  It’s important to consult individuals within the ETF ecosystem who can help you decide if your unique active strategy fits well within the ETF wrapper. 

About the Author

Dom Dalmaso, CFA, CAIA is the CIO and co-founder of Sound Capital Solutions – an Investment Adviser offering both White Label services and a unique Solutions Provider offering that provides clients with the tools to act as their own ETF Adviser.  He began his career in investment sales before his current role as the primary investment professional aiding in product development and management, complementing areas of expertise and knowledge with partners at Sound Capital Solutions. 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.