In some circles it’s called a “liquidity sleeve”—that sliver of exchange-traded fund (ETF) exposure that can keep at least a portion of your exposure liquid in case you need to liquidate in a hurry.
For active managers, however, ETFs have another use: as a tool to avoid the dreaded “cash drag”— that 3% to 5% hit on performance that comes from holding the necessary cash to manage investor redemptions.
That’s all according to a recent rundown of ETF use among active managers in this Reuters article last week. According to Reuters, the number of actively-managed equity funds with ETFs among their top 10 holdings has risen 174% to a total of 148.
Active managers have been working to reduce cash drag at a time when their performance is under the microscope. Increasingly, they are coming under pressure to justify their higher fees as it gets tougher and tougher to beat benchmarks.
Last year, only one out of five mutual fund managers outperformed their respective benchmarks—it’s the worst performance in over a decade.
As that has happened, money has been flowing into ETFs at an ever-increasing pace—last year, investors moved a quarter trillion dollars into U.S.-listed ETFs and here in Canada, ETF assets grew by 21%.
And while ETFs are still small potatoes compared to the mutual fund industry, they are becoming a growing part of it.
The question for investors however is can ETFs really contribute to the performance of an actively managed fund, particularly when they are designed to track rather than beat the benchmark. In some cases, yes. But in others the strategy can backfire.
Some actively managed funds are using ETFs and performing well—notes Reuters, the William Blair Small Cap Growth fund has outperformed all but 13% of its peers despite holding an iShares ETF that tracks the benchmark Russell 2000 index as its top holding in its most recent portfolio.
In other cases, however, the benefits might not be so clear. One obvious advantage of cash is protection during down markets. That doesn’t happen with ETFs, which is why some managers only hold them for short periods of time and in limited quantities. And some are compelled to turn to ETFs temporarily when direct holdings are hard to come by.
Bottom line—active managers can and should be using ETFs as a tool in their own portfolios. The trick for investors however is to look closely at how ETFs are being used by active managers and whether or not they’re contributing to performance.