Will my active fund turn into an ETF?

If someone tells you their investment portfolio mostly consists of exchange-traded funds (ETFs), what does that tell you about their preferred approach to investing? Generally, you will assume they are a fan of passive investing.

You will also likely assume that they do not believe it is worth trying to invest with active fund managers aiming to provide returns above the market average. Instead, you will assume, this hypothetical ETF investor believes the best approach is to simply track broad indices such as the S&P 500, FTSE 100 or MSCI World.

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Right now, such assumptions would not always be wrong. Over their 30 years of existence, ETFs have become synonymous with passive investing. The world’s biggest ETF tracks the S&P 500, while broad indices tracking ETFs typically top the charts into terms of inflows on most-bought lists, including interactive investor’s monthly league tables.  

However, within a few years such assumptions will become out of date. In due course, the ETF wrapper will no longer be synonymous with a particular style of investing. ETFs are just a fund wrapper. Any investment style can be offered inside the ETF wrapper, including actively managed portfolios.

Indeed, this is already starting to be the case in the United States. Over recent years we’ve seen big-name fund managers such as T. Rowe Price and Fidelity venture into the active ETF space. And the trend is picking up pace. In the second quarter of this year, most ETFs that launched in the US were active ETFs.

Of course, product launches are only supply. The real test is whether demand follows. On that front, the numbers are also impressive. During the first half of 2024, actively managed ETFs accounted for 31% of all money flowing into ETFs. A big indication that this trend is here to stay is shown through BlackRock forecasting that global assets in active ETFs will quadruple from $900 billion today to $4 trillion by 2030.

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This trend is just getting started in the UK. Over the past few months several big-name fund houses have announced their entrance into the ETF market. Guinness Global Investors recently launched its first ETF available in the UK, Guinness Sustainable Energy UCITS ETF (CLMA). Meanwhile, Janus Henderson recently acquired the ETF issuer Tabula as a means to enter the active ETF market in Europe. Other active fund houses have also announced their intention to start creating active ETFs.

So, it is fair to say that the deluge of active ETFs seen in the US will soon be coming to our own shores? From the perspective of fund houses entering the ETF world, it is a matter of “enhanced distribution”. That simply means offering their investment strategies in as many fund wrappers as possible. Many fund houses run similar or identical strategies as both open-end funds and investment trusts. As the ETF wrapper becomes more popular, particularly among younger investors, why not add it to the roster?

But alongside fund houses offering an ETF version of their strategies, we can also speculate about closed-end investment trusts. A key feature – and often attraction – of investment trusts is the fact that their share prices can trade on a discount or premium to the value of the assets they hold. The investment trust sector average discount at the end of June this year was -14.5%.

While some investors like this feature due to the potential ability to buy shares in a trust at a wider than usual discount, for others it can be a source of frustration. A trust can trade at a discount to its underlying assets simply because investor enthusiasm for a particular asset class, strategy or portfolio manager has waned.

For fund houses running an investment trust at persistent discounts, a conversion to an ETF offers a potential immediate (albeit one-off) boost of returns for shareholders. The core feature of an ETF is the creation/redemption process, which ensures share price and net asset value remain tight. This process is carried out by so-called authorised participants, key players in the ETF ecosystem.

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If an investment trust converted to an ETF, these authorised participants would immediately work towards closing that discount by buying shares on the open market and trading them with the asset manager for a basket of the underlying assets in the portfolio. So, if an investment trust was trading at a -10% discount, that discount would quickly close, resulting in a nice return for existing shareholders.

This would, of course, only work for investment trusts that invest purely in publicly listed stocks or bonds. It would also result in a loss of ability for investors themselves to try and profit from swings in discounts and premiums. Of course, any such conversion to an ETF would be approved by shareholders of the trust itself. Ultimately, therefore, it would be up to investors themselves to decide. But I suspect many will find the potential windfall from the closing of the discount to be an attractive proposition.

So, in a few years, if someone says they are an ETF investor it might give you very little insight into their preferred investment style. The link between strategy (passive index tracking) and fund wrapper (ETF) will have broken down. If someone says they are an ETF investor, it will simply denote that they prefer using a fund wrapper with full transparency on holdings and the ability to buy and sell the fund throughout the day.

Tom Bailey is head of research at HanETF.