The rise of active ETFs over the past year has been the big story with Kenneth Lamont, Principal of Manager Research at Morningstar and based in London, noting that the number of active ETFs in the US now surpasses the number of passive ETFs.
Lamont notes that the ETF business in the US has different drivers, with the rise of platforms that only accept ETFs and the tax advantage which drives more significant growth than is seen in Europe.
“US players have imported successful strategies over and see that growth in the US and anticipate seeing the same thing here, but it’s not driven by client demand, it’s not fund selectors demanding active ETFs,” Lamont says.
The ETF wrapper has already had its benefits diluted with the semi-transparent model, Lamont says and that diminution continues with active ETFs, he believes.
“So the advantages of the ETF wrapper is low-cost transparency and flexibility and these are reduced in active ETFs as they tend to charge more than passive funds and can be less transparent.”
The big US players that have launched ETFs in Europe are here because it is a natural port of call for them, Lamont says.
“It’s a real headache for asset managers here, feeling that they missed the boat on ETFs the first time round and that there is a buzz here, but how do you price your fund if you have an identical fund inside an ETF wrapper?
“If it’s an identical strategy to a mutual fund, what are the benefits? If you price it less, will you directly cannibalise your own product? So, they follow what the market has chosen, which is screened beta plus type with added secret sauce and charge a bit less for it.”
Another difference between ETFs and active funds in other formats is that they are sold in different ways, Lamont says. “It’s an ongoing relationship with their investors for active managers, a personal relationship.
“With ETFs you are one step removed as you don’t know who exactly is invested in your product.”
He also comments: “Active managers think they are getting the jump on something by being a first mover and they may well be, but actually what happens if the light version outperforms the heavy one? And, ideally don’t cannibalise your own range but it’s easier said than done. The ETF wrapper is much cleaner and more comparable so it’s harder to hide kickbacks or added fees.”
Lamont also has views on the ESG backlash where, as he puts it, particularly in the US, ESG funds have been pummelled.
“There has been a broad and thematic rise in defence, the profitability of traditional energy and the rising power of AI and it won’t stop this train,” he says.
“All tied into one of the potential inhibitors to the growth of AI is the energy consumption. We haven’t got enough energy capacity to meet these grandiose projections of AI usage.”
AI usage is split into funds that use it in their index creation and those who use it in their back offices and processes which will become everywhere.
However he notes that an ETF that uses AI to create its portfolio is very black box.
“How do you differentiate from tools we have been using such as NLPs and neural networks? As a fund selector I would pare things right back to a sceptical position and if you can be convinced but if you don’t understand it – don’t invest.
“If we speak to fund managers we want to understand as much as possible how AI is used, and we are the first wave of understanding it. What is AI and what isn’t? No one is policing this term.”
Research from Morningstar has revealed that the global AI ETF pool is dominated by MAG 7 stocks, with nine out of 10 of the portfolios holding Nvidia.
“It’s caused a headache for managers whether it’s active or indexed because almost all investors have exposure to the MAG 7 stocks.”
As AI ETFs try to diversify away, they sometimes end up in unexpected stocks, such as Walmart and Tesco, because these are firms that will benefit from the growth of AI.
“They allocate away to more interesting interpretations of the value chain, from chip manufacturers to firms building the data centres and those developing the algorithms to businesses that will benefit.
“Essentially AI development is being funded by the US and Chinese governments so it’s become a space race because if you don’t do it, someone else will and you will fall behind – even though there isn’t an end goal.
“An ex-US AI fund and ex-US MAG 7 fund might be more complementary but there are also reasons why AI won’t develop as we think it might because of geopolitical issues such as the US and China completely falling out and those knock-on implications.”
One of the criticisms of thematic investing is that by the time you hear about it most of the growth has gone, Lamont says.
“The question is actually where the value in AI is and where the most revenue will be. It could be in the users of AI in their own businesses to increase the bottom line and to improve margins.”
