iShares made quite a splash last week after launching its first actively managed equity ETFs. But what made my jaw drop wasn’t iShares’ moving more deeply into the active space, but the low costs of the two funds.
It’s long been accepted that investors wanting active management pay higher fees for the research and stock selection provided by “expert” fund managers.
In the mutual fund space, investors often pay hundreds of basis points for this. Even in the ETF space, active funds often charge close to or higher than 1 percent a year in fees.
In comparison, the iShares Enhanced US Large-Cap ETF (IELG) and the iShares Enhanced US Small-Cap ETF (IESM) provide investors with access to BlackRock’s active equity research capabilities in an ETF wrapper for only 18 and 35 basis points, respectively.
Just to put into context how incredibly cheap that is, of the 61 active ETFs across all asset classes currently in existence, the average expense ratio is 1.07 percent. The most expensive active fund is currently the AdvisorShares Accuvest Global Long Short ETF (AGLS), with a net expense ratio of 5.86 percent, or $586 for each $10,000 invested.
That’s sky-high, but even the iShares Diversified Alternatives Trust (ALT), an active multi-asset-class ETF that has been around for more than three years, comes in at a still-high 0.95 percent a year.
So, IELG’s 18 basis points is now not only the cheapest active equity fund, it’s also the cheapest of all active ETFs, including fixed-income funds. IESM’s 35 basis points, meanwhile, is the fourth-cheapest, only behind IELG and a few fixed-income ETFs. Even within iShares’ suite of 288 index-tracking ETFs, the average expense ratio is 0.41 percent. This puts the two new active funds well below that level.
It’s worth pointing out that simply because an ETF is cheap doesn’t necessarily make it a steal. Historically, most active funds have underperformed the broad market.
I think it’s fair to say that most investors would prefer to pay more for a fund with a history of outperformance, over a cost-effective fund that significantly lags the broader market.
That said, let’s do a dive into the funds’ investment strategies.
According to the prospectus, IELG’s stock-selection process involves a lot of fundamental factors, including earnings and price-to-book, as well as size factors like market capitalization, specifically targeting the lower end of the large-cap spectrum.
Consistent with its investment strategy, IELG currently has a 25 percent weighting in what we consider midcaps, or companies with market caps between $600 million and $2.7 billion. IELG also carries a value tilt, based on its lower price-to-earnings (P/E) and price-to-book (P/B) ratios compared with a neutral, cap-weighted large-cap benchmark.
IESM’s selection process is similar to IELG’s, looking at both fundamental and size factors. IESM tilts even smaller than a neutral cap-weighted small-cap benchmark, with 31 percent in micro caps (companies with less than $600 million market cap); and 64 percent in companies with market caps of more than $600 million but less than $2.7 billion. Again, it has somewhat of a value tilt, with a lower P/E and P/B.
Thus far, active equity funds have not generated much interest. There’s only $754 million among 17 active equity ETFs, which amounts to only 0.07 percent of the $1.08 trillion in all equity ETFs.
I’ve long felt that the active space will blossom when more well-known mutual fund managers eventually enter the ETF space, the way Bill Gross did with the $5.1 billion Pimco Total Return ETF (BOND).
We’ll see if IELG’s and IESM’s ultra-low costs will be enough to lure investors to the active equity space. One way or another, they provide a low-cost option for long-term investors wanting active management.
iShares’ new active launches have set the bar higher, at least in terms of costs, around actively managed equity ETFs. Ultimately, I think investors will pass judgment on the two funds based on their performance relative to the broader indices.
At the time this article was written, the author held a long position in BOND. Contact Dennis Hudachek at firstname.lastname@example.org.
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