By Detlef Glow Click to enlarge The Evolution of the European ETF Industry When the first exchange-traded fund (ETF) was introduced to the markets, it was clear that the aim of the portfolio manager was to track the returns of the underlying index of the fund as closely as possible. But since a fund faces some restrictions, such as transaction costs or limits on the maximum weighting of a single security in the portfolio, that are not applicable for the underlying index, the difference between the returns of the index and the ETF are in some cases quite significant. Since the investment industry (and therefore also the ETF industry) is always trying to optimize its processes, ETF promoters started to develop portfolio management techniques to minimize tracking error and the tracking differences of the ETFs. The Generation 2.0 ETFs not only aimed to track the performance of the underlying index as closely as possible, the managers also attempted to optimize the returns with modern portfolio management techniques to achieve additional income that contributed to their outperformance over the index. Looking at ETFs that try to generate outperformance the “old fashioned way,” the additional income must be seen as tracking error and therefore as a negative fact. These returns were, firstly, non regular returns. Secondly, modern portfolio management techniques such as securities lending or dividend optimization strategies added an additional layer of risk to the portfolio, for which the ETF investor might have not been compensated properly. Even though the quality of ETF returns has evolved significantly, there are still a number of critics around, since it seems in some cases to be easy to beat market-capitalization-weighted benchmarks. In other cases, such as with bond indices, critics say that market capitalization is the wrong way to build an index. These criticisms have led to the development of alternative weighted indices, ranging from simple equally weighted indices to highly complex methodologies that might employ quantitative and qualitative factors to determine the weighting of the securities in the index. But, even though some promoters offer ETFs that track an alternative weighted index, these kinds of products have not found their way into the portfolios of mainstream investors. But there was and still is scientific evidence that there are some factors in the markets-such as momentum, quality, size, and value-that investors can exploit to generate higher returns than those from a market-cap-weighted index. The introduction of these factors into the mainstream ETF industry started after the financial crisis of 2008 with the first minimum variance ETFs that suited the needs of investors looking for equity portfolios that don’t show as much volatility as their underlying markets. To make these products more appealing for investors, the ETF industry called these kinds of funds “smart beta funds.” The popularity of these products led to a race in the search for new factors that can be exploited by investors, since the index and ETF promoters wanted to offer new products to their clients. But the “new factors” found by the researchers were mainly market abnormalities that disappeared shortly after they were found, or the additional returns were too small to exploit in a profitable way, since transaction costs were eating away the premium. One of the major concerns of investors with regard to smart beta ETFs is that all the factors employed do not deliver consistent outperformance. In other words, smart beta ETFs show longer periods of underperformance that make it necessary for the investor to switch at the right time between different factors to avoid the longer periods of underperformance in their portfolio. But since the right timing is the hardest call in the portfolio management process, especially for retail investors, it seems likely that a number of investors shy away from these products. In the next product generation, the index and ETF industry are attempting to make the smart beta products even smarter by combining different factors. The products improve the common smart beta ETFs. In other words, they make the smart beta concept even smarter, since the factors described above do not deliver outperformance at any particular time. One of the aims of this approach is to build a portfolio that is either in different factors at the same time or that tries to switch between factors at the right time, i.e., to unburden the investor from the timing decision in order to capture as much premium from a single factor as possible. From these semi-actively managed portfolios it is only a small step to a fully active managed portfolio wrapped in an ETF structure. Even though some market observers would label this a scandal, the introduction of actively managed ETFs will be the next logical step for the industry. Even though the first ETF following an actively managed index in Europe wasn’t a success at all, a view to the other side of the Atlantic shows that actively managed ETFs can be successful. PIMCO was able to generate very high inflows when it launched its first actively managed ETF in the U.S. The success of PIMCO might be the reason more and more promoters of actively managed funds are preparing to enter the ETF market. From my point of view this makes a lot of sense, since the ETF wrapper is a very efficient structure that opens up new distribution methods for active managers. And, I don’t see a valid reason why promoters should not try to distribute their funds through all possible channels. But to be successful active ETF managers must not only have good products, they also must build the right infrastructure for trading their funds. To be successful in the ETF industry there needs to be more than a well-known name and the listing of products on an exchange. I strongly believe this introduction will work; we already see a number of active managed funds listed by market participants on the “Deutsche Börse” in Frankfurt. At the beginning the fund promoters did not support trading their funds on exchanges and in some cases tried to close down the trading, since they felt this distribution channel would offend their established distribution channels. Those times are over, but it is still not common to buy or sell a mutual fund on an exchange unless the fund has been closed for some reason. From my point of view the trading of actively managed ETFs will become a very common way to buy mutual funds for all kinds of investors, once fund promoters officially start to use this market as a distribution channel. It is not a question of if we will see actively managed funds traded as ETFs, it is only a question of when we will see this happen. The views expressed are the views of the author, not necessarily those of Thomson Reuters Lipper.