Price-taker accusation 'couldn't be further from the truth'

The accusation that ETF portfolio managers are risking investors’ capital because of a one-eyed focus on AUM has been rebuked by an industry insider.

Alfred Lee, a portfolio manager at BMO Asset Management where he manages fixed income and preferred shares-related mandates for institutional and retail clients, told WP this was a typical misconception about ETFs among active managers and the general media.

Rather than obsess over AUM, Lee said that at least 50% of his desk’s job is based around educating investors about how to use ETFs and then providing meaningful solutions at a "cost-effective price". If this works for an investor, AUM is a natural by-product, Lee said, adding that the idea passive fixed income managers are price-takers could “not be further from the truth”.

While an active manager can go out and find a security that’s undervalued in order to add value and generate alpha at a certain price, Lee said a passive manager is bound by even tighter price considerations.

He said: “We’re not out there trying to generate alpha, we're trying to match an index so what we're most sensitive on is actually price. If we get a bad price on a certain security, that's going to show up in tracking error right away. We’re very price sensitive, so it's actually quite the opposite.

“Also, when a lot of people think about ETFs, they assume that we own the entire index. On the fixed income side, it’s an inventory based market unlike the equity market where if we build an ETF that tracks the S&P 500 - we go out there and buy the 500 securities in the exact same way the index does.

“With fixed income, it's an optimized or a sample process, where will own a subset of the index by using a sample of the underlying index. Because of that, we don't have to own every individual security, so if I don't get a good pricing on a certain bond, I could pass until I find bonds that are trading at a fair price. We’re not price-takers; we’re actually quite the opposite.”

Lee insisted he does not believe active is better than passive and said there is use for both in a portfolio – his desk also oversees a few active funds. However, he said there has been a shift in the industry represented by the growth of ETFs versus the relative stagnation of mutual funds.

It’s led to advisors becoming more interested in building portfolios and getting exposure to different asset classes or a certain strategy, like being overweight government bonds, for example. Frustration among active managers on the fixed income side may represent the fact they live in an environment which is proving harder to outperform.

Another perception Lee took aim at was the thinking that the growth of ETFs was hurting the overall market. He said mutual funds still dwarf the ETF market, which is about 12% the size, and stressed that the price impact of active managers is going to be more significant.

He said: “The misconception that ETFs cause a lot of dislocations in the market is because with ETFs, you can see the volume traded, whereas with mutual funds, you don't really see that.

“The benefit of an ETF is that when you look at a mutual fund, all the buyers and sellers are, for the most part, going to be retail investors, so they buy and sell for very similar reasons. With an ETF, anybody that could trade on an equity exchange has access to an ETF, so you have a more diversified liquidity pool of retail investors, institutional investors, DIY investors, hedge funds, whatever it may be, and they're buying and selling for different reasons.”

Liquidity, or the lack of it, is a hot topic but Lee said fixed income ETFs are not to blame, pointing to a Bank of Canada report that said these funds actually add liquidity to the market because of the secondary level of trading of the ETF units themselves.

Lee added: “If you're going out and buying or selling an ETF, chances are you're buying and selling that ETF off an ETF user. The market-maker or us as a portfolio manager, we don't have to go out and trade the underlying securities.

“That secondary level layer of liquidity tends to enhance liquidity for a lot of investors. That’s why we’re seeing a lot of mutual fund investors and pensions start to use ETFs as part of their portfolio.

“For example, if they're managing bonds or high yield, they'll hold a small piece in an ETF in order to manage their liquidity. If they do get redemption in their fund, they could just simply sell the ETFs to raise cash.”