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Bill Miller And Active ETFs

Paul Britt

Bill Miller’s value-oriented mutual fund had a great run, besting the S'P 500 for 15 straight years before losing his way in the 2008 financial crisis.

Miller can look back at a long career as a stock picker. But unlike the mutual fund world, ETFs that specialize in active security selection never really took off. And it’s an open question whether they ever will.

Before I look at why this is, a peek at today’s active ETF landscape might help.

Active ETFs hold less than 1 percent of all ETF assets, with roughly $5 billion out of a $ 1 trillion ETF pie.

Of active ETF assets, equity and alternative funds—classic stock-pickers—make up less than 10 percent. Instead, fixed income rules the roost, gobbling up two-thirds of the active ETF pie.

Managers arguably have greater capacity to add value in the fixed-income space.

Firms typically issue many different bonds, but only one common stock. Bonds trade less frequently making price discovery harder, with the exception of U.S. Treasurys.

Also, good fixed-income information is expensive. And getting the analysis right isn’t easy. Just ask the rating agencies. Sovereign, municipal and asset-backed debt each call for special skill sets.

Little wonder then that two fixed-income ETFs dominate assets:the Pimco Enhanced Short Maturity Strategy Fund (NYSEArca:MINT - News) and the WisdomTree Emerging Markets Local Debt ETF (NYSEArca:ELD - News).

MINT leverages the reputation of bond maven Bill Gross. ELD hunts for credits in a universe where paying a bit extra to have someone to pick the bonds in your basket might seem like cheap insurance.

But the hefty assets in these two funds are the exception, not the rule. As the numbers show, active ETF assets are dwarfed by passive. What gives?




Tipping Your Hand

ETFs tout transparency as a key feature. But for active ETFs, broadcasting holdings to the world makes no sense.

Active managers focus on security selection. If their positions are immediately published, others can mimic them without doing any of the work.

In the bond space though, it’s harder for free-riders to hop on because the manager’s chosen bonds might be hard to buy.

Some firms, notably iShares’ parent company BlackRock, have filed for nontransparent ETFs , which would address this issue of preserving a manager’s “secret sauce.”

The idea of a nontransparent ETF has yet to catch on though, and would certainly raise the hackles of those on the passive side of the soul-of-indexing discussion.

Success Breeds Failure

There are other arguments against using active strategies in an ETF wrapper.

Active managers typically exploit some kind of mispricing or inefficiency. They often focus on a narrow aspect of the market.

If a manager is skilled or lucky enough to find an advantage, who’s to say it can support a large inflow of funds once word gets out? Joel Dickson of Vanguard made this point in one of our recent webinars .

Liquidity matters too. Hedge funds and private equity partnerships know that identifying, funding and unwinding investments takes time. They require investors to commit their capital for extended periods.

While the comparison of these vehicles to active ETFs isn’t perfect, it highlights the idea that control over the timing and size of capital deployment can be critical to the success.

What’s In A Name?

Indexing purists argue that active ETFs actually have huge market share. They’re just hiding in plain sight in the form of “active” indexes. For example, funds that track RAFI, Intellidex and AlphaDex indexes stray far from the market-cap selection and weighting path, but are still considered passive by most.

In my view, these “active index” products may be the best blend of active investing with the ETF vehicle. The holdings are transparent, and for the most part, so are the methodologies.

The scalability and liquidity of the ETF structure doesn’t hurt the funds’ opportunity set. Their rules-based performance will, in turn, beat and lag the market, just like that of active managers.

All this brings us back to Bill Miller.  Fifteen years of outperformance is hard to argue with. That he faltered in the end just highlights the difficulty of the preceding feat.

It also reminds us of the downside risks taken whenever we try to beat the market.


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