Active solution is within reach

It has been talked about for years but 2007 might be the year that the first actively managed exchange traded fund makes it to market.

ETFs, baskets of securities designed to track indices and trade like stocks, have been the hottest investment vehicles going in recent years.

The potential for an actively managed ETF is widely seen as “the Holy Grail of the industry”, writes David Haywood, the director of alternative investment research at Financial Research, the Boston-based data company, in a recent research report.

After all, Mr Haywood says, the prospect of an actively managed ETF offers distributors “a way to tap into the $7,000bn actively managed fund business and opens up new distribution channels – including institutional markets and global markets”. It would also “allow managers to remain fully invested, since no cash position is needed for investor redemptions, and work as a lower-cost share class for investors”, he writes.

First introduced by State Street in 1993, assets within ETFs have increased 362 per cent from $83bn at the end of 2001 to $383bn today. A record 144 ETFs were launched last year, specialising in everything from gold to biotechnology to Korean companies. To put that figure in perspective, the total number of ETF launches in 1996 was 17.

Lee Kranefuss, head of US individual investor business at Barclays Global Investors, the biggest ETF provider in the US, says he is intrigued by the possibility of providing active ETFs to investors.

“We are one of the world’s great active managers,” he says, “and we’d love to get some of those strategies out to ETF investors.”

In recent years, a slew of “semi-active” ETFs have arrived. Traditionally, ETFs are based on conventional indices and are weighted by market capitalisation, but lately ETF providers are launching funds that incorporate alternative weighting strategies. These ETFs, which modify or aim to improve on traditional benchmarks, look for above-market returns.

PowerShares, for instance, last year launched 10 ETFs that weight stocks based on revenues, book value, cash flow and dividends, instead of by market capitalisation.

Meanwhile, First Trust introduced a value-weighted index that measures the average performance of US initial public offerings during their first 1,000 trading days.

Also among these so-called “enhanced” ETFs are 20 funds from WisdomTree that track dividend indices and a new ETF from Claymore Securities that selects stocks based on market sentiment and aims to identify companies with favourable corporate insider-buying trends and Wall Street analyst upgrades.

But many in the industry are not persuaded that these funds are indeed actively managed.

“If I am going to try to do any active product, we will call it an active product,” says James Ross, senior managing director of State Street Global Advisors, the investment management arm of State Street. The company recently consolidated its offerings under the singular umbrella brand SPDRs.

In a speech this autumn, Andrew Donohue, director of the Securities and Exchange Commission’s investment management division, said the US regulator was trying to figure out what to do with proposals that would bring actively managed ETFs to market. (There are at least two applications filed with the SEC for an active ETF.)

After all, active ETFs already exist in markets outside the US. Mr Haywood says: “The introduction of active ETFs in Germany and Australia has, if nothing more, demonstrated the concept’s viability and given US regulators and product management teams at asset managers an opportunity to study the product in a real world context.”

But Ron DeLegge, editor and publisher of ETFguide.com, a San Diego-based website, says that the potential of active ETFs has been “way overplayed”.

“It would definitely be an important point in the development of ETFs,” he says, “but it’s not going to be something that fundamentally changes the industry. You’re going to have the same headaches that you have with other actively managed fund products – namely poor performance. The ETF shell doesn’t matter.”

Mr DeLegge says he is also concerned that active management could detract from ETFs’ tax advantages. Unlike mutual funds, ETFs do not need to sell their holdings to meet shareholder redemptions, which helps to minimise capital gains distributions.

It is likely that an active fund manager that is choosing stocks would incur more turn­over and therefore realise more capital gains not recognised by ETFs’ in-kind redemption feature.

Active management could also dent ETFs’ cost-effectiveness, Mr DeLegge says. He worries that fund providers would add hefty fees to pay for the talent of the manager.

In addition to these concerns, there are many logistical and regulatory hurdles to introducing active ETFs. Perhaps the biggest obstacle is transparency, says Mr Haywood.

The SEC requires that ETFs disclose their holdings every day, whereas regular mutual funds are required to disclose their holdings every six months.

But active managers do not want to divulge their holdings for fear of being front-run by the market.

The concern is that hedge funds would notice when an ETF buys a particular stock and then buy that stock themselves on the theory that the ETF will continue to add the stock to its portfolio in the days and weeks ahead. This would naturally drive up the price the ETF pays for its shares.

“We and others have been looking for ways to resolve that conflict [of daily disclosure],” said Mr Kranefuss. “We haven’t worked out how to do it, but it’s always when, not if, with the ETF market.”

One proposed solution is disclosing a “proxy” portfolio that is similar to the portfolio but not exactly the same. This would allow specialists to hedge their positions while preventing traders from figuring out the real fund’s composition.

Tom Fox, chief investment officer of Quantitative Advantage, a Minneapolis asset management firm that builds portfolios using ETFs, is sceptical. “If the index is actively managed, we can’t keep track of what’s in the fund. And we like to know what we’re getting,” he says.

Concerns over transparency represent a big difficulty for fund companies that may be considering introducing active management. In other words, while there is a big competitive advantage to being first to market with a standard index fund – because of built-up demand and the fact that there are few ways to differentiate index funds – there is a steep cost to being first with active management.

ETF providers need to make sure they are satisfying the needs of the trading community for full transparency, protecting the shareholders and making the regulatory bodies comfortable.

So far these hurdles have been too great to overcome, which is why fund companies – many of which say they are reviewing the issue – appear to be waiting for someone else to make the first move.

Still, that first move is imminent, according to Mr Haywood. “Active ETFs would present a game-changing opportunity for many manufacturers and distributors,” he says.

“This is clearly an area to watch as, once the first active ETF makes it to market, the floodgates will open.”

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