A deep dive into active ETFs and total cost of ownership

In today’s competitive ETF landscape, understanding the full spectrum of costs beyond the headline fee is essential. This is especially true for active ETFs, where tracking differences and asset management strategies can materially impact outcomes.

In this interview, Brieuc Louchard, head of ETF capital markets at AXA Investment Managers, offers a detailed breakdown of total cost of ownership (TCO) and why it goes far beyond just the expense ratio. He explains how structural factors such as liquidity and quality of underlying assets and trading mechanisms play a role in influencing real costs.

Louchard also highlights the growing appeal of active ETFs during market volatility and addresses the misconceptions surrounding costs in active ETFs.

What are the factors underpinning total cost of ownership within ETFs?

When evaluating the total cost of ownership (TCO) for ETFs, it is essential to examine several factors that extend beyond the expense ratio and bid-ask spread. Although these two components are significant, the overall TCO includes both trading and holding costs, as buying or selling an ETF incurs additional fees. Investors should bear in mind that a low expense ratio does not inherently lead to low TCO and vice versa.

The expense ratio captures the ongoing costs related to an ETF’s annual management and is reflected in its net asset value (NAV). In contrast, the bid-ask spread represents the difference between the maximum price a buyer is prepared to pay and the minimum price a seller is willing to accept, leading to a direct cost during transactions. Similar to how Europe consists of many countries, the European UCITS structure has multiple stock exchanges and multilateral trading facilities.

Most of the trading happens over the counter or through request-for quote (RFQ) platforms. These platforms allow institutional investors to execute large trades with tighter spreads and reduced market impact, often improving pricing versus visible on-screen quotes. The primary factors influencing real spreads on RFQ platforms include the liquidity of the underlying securities and the quality and flexibility of the ETF’s primary market. Strong underlying liquidity is crucial, as it helps maintain tighter spreads, while the efficiency of the ETF’s primary market can significantly impact the overall trading experience. Although trading volume plays a role in spread dynamics, it is essential for investors to understand these essential aspects first. Increased market volatility can also affect spreads, making it vital for investors to stay informed about the macro environment.

Another critical factor to consider is the occurrence of premiums and discounts. The creation-redemption process generally helps align ETF prices with their true value; however, large premiums or discounts can introduce risks. Investors might find themselves acquiring an ETF at a premium and then selling it at a discount later, emphasising the importance of monitoring the volatility of these effects.

Tracking error is also a key aspect impacting TCO for index-based ETF. It indicates how consistently an ETF’s performance tracks its benchmark over time. Higher deviations from the benchmark require more frequent trading to realign with the benchmark. This can create additional costs above those fees explicitly associated with the ETF, which can eat into the return investors receive.

Finally, market impact costs can accumulate, especially with larger transactions. As the popularity of ETFs increases, understanding market liquidity becomes essential for achieving optimal trade execution. Thus, a thorough liquidity analysis should form part of the due diligence process, as relying solely on an ETF’s stated expense ratio may not yield the most cost-efficient investment outcome.

AXA IM has a dedicated ETF Capital Markets team that manages all relationships with brokers, authorised participants, market makers, stock exchanges, MTF and RFQ platforms. The Capital Markets team also assists investors through the trading experience to minimise costs and guide them through the different trading options for both buying or selling the ETF.

What are the less apparent costs to consider when investing in active ETFs?

When investing in active ETFs, it is crucial to consider less visible costs that can impact overall performance. As noted earlier, the bid-ask spread is a key expense. As active ETFs continue to make their way into the European market, it is important for investors to understand the trading costs associated with these funds while pursuing the potential for after-fee alpha. Generally, active ETFs feature slightly wider bid-ask spreads compared to passive alternatives. This indicates the potential uncertainty market makers experience regarding the portfolio manager’s ability to modify the fund’s composition. In contrast, index-based ETFs follow an index governed by a detailed set of rules that is publicly available. Moreover, well-known indices typically have related futures and options contracts, enabling market makers to hedge their positions more effectively. This highlights the importance of maintaining effective communication between the ETF Capital Markets team and market makers, ensuring they have timely access to the information necessary to achieve the narrowest spreads possible.

With growing demand for active ETFs in Europe, we expect to see a trend toward tighter bid-ask spreads, which should enhance the liquidity profile of these funds. This development is anticipated to lower trading costs, making active ETFs more attractive to investors who prioritise efficient trading.

Despite apprehensions regarding the costs tied to active ETFs, many of these funds are competitively priced, with fees that are comparable to those of passive counterparts and generally lower than those of active traditional mutual funds. This creates a favourable balance within the cost spectrum. Furthermore, the liquidity inherent in active ETFs provides the flexibility to make tactical adjustments to long-term strategic portfolios, facilitating swift and cost-effective rebalancing in response to evolving macroeconomic conditions or revised investment strategies.

Can active ETFs truly deliver value net of fees especially in volatile or sideways markets?

Active ETFs could indeed offer value net of fees, particularly in volatile or sideways markets. A significant benefit of these funds lies in their capacity to generate alpha, which means delivering returns that exceed those of a benchmark. Although active ETFs typically come with higher fees compared to passive counterparts, the potential for enhanced long-term returns can justify these costs, making them attractive to discerning investors.

In the context of today’s rapidly changing market environment, flexibility is essential and active ETFs facilitate quick adjustments to asset allocations. This adaptability empowers portfolio managers to respond effectively to market fluctuations, especially during periods of volatility that present both risks and opportunities.

Additionally, our active ETFs are closely integrated with our fundamental portfolio management teams, allowing us to draw on a variety of investment strategies to uncover relative value opportunities across multiple sectors. This targeted approach seeks to improve risk-adjusted returns for our ETF investors, highlighting the significant advantages of active management in challenging market conditions. In this dynamic landscape, opportunities are plentiful, and active ETFs are strategically positioned to capitalise on them. This strategy not only helps mitigate capital losses in fluctuating markets but also contributes to the overall net value generated beyond the associated fees.

Important information

No assurance can be given that AXA IM’s investment strategies will be successful. Investors can lose some or all of their capital invested. These strategies are subject to specific risks including, but not limited to: equity; emerging markets; global investments; investments in small and micro capitalisation universe; investments in specific sectors or asset classes, volatility risk, liquidity risk, credit risk, counterparty risk, derivatives risk, legal risk, valuation risk, operational risk and risks related to the underlying assets. Some strategies may also involve leverage, which may increase the effect of market movements on the portfolio and may result in significant risk of losses.