Active ETFs

Should investment trust buyers be looking at active ETFs as well?

There have been no new investment trust IPOs in two years, but many active ETFs are emerging. This week, Janus Henderson launched a new Japanese equities active ETF, which could have been an investment trust. Active ETFs are booming in the US and launching regularly in Europe. We explore the key differences and similarities.

By David Stevenson

The whole investment trust sector has to fight for new money inflows, but barely a week goes by without news of some new active exchange-traded fund launch. Just this week, for instance, came news that Janus Henderson – a major player in the investment trust space – announced the launch of its first active ETF in Europe: the Janus Henderson Tabula Japan High Conviction Equity UCITS ETF (JCPN). According to the manager “the fund will adopt a high conviction approach and invest in an actively managed all-cap concentrated portfolio of 20 to 30 holdings, providing exposure to companies that are set to benefit from structural themes and trends in the Japanese Equity market, and showcasing the best of Janus Henderson’s stock selection skills. The launch of this active ETF represents an important milestone for Janus Henderson, allowing the firm to cater to client demand globally for its investment strategies to include a UCITS ETF wrapper; and builds upon the firm’s extremely successful active ETF proposition in the US where it is fourth largest provider of actively managed fixed income ETFs.”

That last sentence should be of particular concern to investment trust fans – active ETFs have been growing exponentially in the US, with many big fund managers getting behind the space with huge marketing pushes. Remember that the US also has a vibrant closed-end fund space that echoes the UK investment trust sector. What should be especially concerning is that the Janus Henderson Japanese fund could have been an investment trust, but the manager has chosen to use an active ETT format.

This news prompts an important question: Are active ETFs and investment trusts very different structures, or are there many similarities? Put another way, are active ETFs and investment trusts fighting for the same investor attention? 

Many fund managers publish useful guides to ETFs to help explain the similarities and differences. I’d highlight this one from AXA and this one from JPMorgan as helpful. In this article, I want to simplify the explanation so that investors can make up their own minds.

The first point is that an active ETF differs from a traditional passive ETF in one very important way. In the latter, a fund manager identifies an index, such as the FTSE 100 or the S&P 500 and then replicates or tracks that index passively. If Nvidia suddenly doubles as a holding in the S&P 500 because of rocketing valuations, then the passive fund will track that change. 

An active ETF might still have an index or benchmark, but its explicit focus is on actively beating the index through its portfolio of active stock or bond picks. In a sense, this is exactly what an actively managed investment trust also seeks to do – if we look at Alliance Witan Trust, it too chooses to reference an index, a global equities index, and then aims to beat that index. So, there is an obvious similarity in investment strategy between an active ETF and an investment trust.  Another similarity is that both investment trusts and ETFs are listed funds, i.e. they have a ticker with a real-time quote for buying and selling shares all day, every day (when the markets are open). That makes them very different from unit trusts, which only issue an end-of-the-day price for underlying holdings which then triggers any buy or sell orders. 

However, the similarities between an ETF and an investment trust stop there. Both a passive ETF and an active ETF are open-end fund vehicles (like unit trusts), which means the manager can issue shares regularly – in fact, daily or even in real-time if they so choose. By contrast, Investment trusts are closed-end vehicles, which means they start with a fixed issuance of shares. That doesn’t mean that the fund can’t issue new shares via a placing programme for instance, or buy back shares regularly, as many investment trusts are doing – but they don’t have quite the same flexibility to change the amount of shares in issue.

The next big difference is the passive and active creation and redemption process in ETFs. This mechanism allows the ETF to trade at close to, or exactly at, the shares’ net asset value. In this complex process, the fund manager issues shares based on the portfolio holdings, which are fully transparent in real-time (in the US there are semi-transparent ETFs but let us ignore that for now). This list of holdings is available to a market-making authorised participant firm, usually a financial intermediary, which can then look at the index and compare it to the fund holdings. If the fund’s assets are worth, say, £100m, but the value of the fund is only £95m, for argument’s sake, the AP can buy the shares and then exchange these shares for a basket of securities  ‘in kind’ , or vice versa.  

The AP can create and redeem shares based on an agreement with the fund issuer. If there is a shortage of ETF shares in the market, the AP can create more ETF shares, and again, this works in reverse as well – they can redeem shares. It all sounds complicated, but the key impact is that there should be a close match between the fund’s net asset value and the ETF share price. This doesn’t mean that an ETF can never trade at a discount to its NAV (or premium), which does happen in some instances with some exotic investments, but for the vast majority of the time, there should be no discount or premium for an ETF. Crucially, this mechanism works for active ETFs as well – instead of an index, we have a model portfolio or basket of shares equivalent to the fund holdings. 

Investment trusts operate in a very different way. Discounts are common in the closed-end fund space, and although managers and boards can use all sorts of mechanisms to close the gap (buybacks and tenders, for instance), many of these don’t move the discount appreciably. 

Another key difference between trusts and active ETFs worth noting is cost and structure. It’s very easy to create an ETF because there is no board of non-executive directors or NEDs, and the fund structure is simplified and streamlined based on a common set of European-wide rules set mainly by Ireland and its central bank under the regional UCITs framework. No sponsoring broker officially launches or IPOs the fund as an adviser, which also helps cut costs. Crucially, suppose you are an active fund manager. In that case, you can probably issue an ETF with just a few million pounds in assets under management and then slowly build it up in scale – most analysts reckon break even for an ETF is probably somewhere between £10m and £50m. And that’s true even though most ETFs charge less than 0.50% per annum in total expenses which is much lower than the equivalent investment trust. The Janus Henderson Japan equities fund, for instance, charges 0.49%. In contrast, most Japanese investment trusts charge between 0.50% and 1% – according to Numis, the average large-cap Japanese equities fund charges 0.81%, while the average small-cap Japanese equities fund charges 1.1%. 

Now, its important to step back at this point and say that the extra structures in place with an investment trust may cost more – you need to pay those directors and broker advisers – but they also provide real protection for investors. If the fund manager underperforms, the board can fire them and find a new manager. That isn’t the case with an active ETF. A closed-end fund structure also provides permanence – this is a long-term commitment of capital unless the fund decides to wind up. With active ETFs, you can start with a few million pounds in assets under management and then remain under the radar for years, not attracting much capital or research interest. Many active ETFs close in the US because they fail to attract much interest and the manager can just decide to close down whenever it suits them – although you will receive your net asset value per share back when the fund closes. 

I’d also argue that the obvious advantage of active ETFs over investment trusts – the discount or lack of with an ETF – can be seen in two ways. Sure, we should expect most active ETFs to trade at their NAV but there is an advantage to buying an investment trust at a discount – you’re buying a collection of hopefully valuable assets at a discount to their ‘real’ (we hope) value i.e. a catalyst emerges that closes the discount. That value opportunity is not good news to the seller of the deeply discounted investment trust, but discounts are an essential feature of the investment trust proposition. 

As for active ETFs, they can serve a slightly different need. They’re great for fund managers looking to sell a fund across Europe quickly and easily. The fund managers can also easily set up different classes of shares for different currencies and even introduce hedged classes of shares – the same goes for accumulating and distributing classes of shares.  For investors, active ETFs can work very well for niche ideas or strategies that might never attract huge sums of capital, i.e. as investment trusts get bigger and more liquid, not all investment ideas will attract hundreds of millions in capital, whereas an active ETF might work well. 

One last point: The nature of the assets. Many active ETFs focus on underlying assets such as equities or bonds that are easily traded, i.e. there is real liquidity in the underlying assets. That underlying liquidity allows the authorised participants to ensure the share price equates to the NAV. Investing in illiquid assets such as private assets (real estate, renewables, or infrastructure) becomes much more challenging. It’s one thing to trade in Japanese equities in real-time (by the way, not always as easy as you think), quite another to sell a wind farm or a stake in a private business. Active ETFs are unlikely, for now, to be very common in these private asset markets, although some managers are pioneering ways of accessing private markets with an index-like structure of more liquid assets. Alternative assets will almost certainly remain a key selling point for the closed-end investment trust sector, giving investors access to less than liquid asset classes usually reserved only for large institutional investors.