The trend in exchange-traded funds is: the more specialised the better. Almost every week flashy new products arrive that slice the stock market more thinly, divide the globe more narrowly and give investors an opportunity to back those hard-to-access asset classes. They are designed to track indices that only came into existence to allow someone to launch an ETF.
With ETFs – baskets of securities that are designed to track indices and trade like stocks – investors can make size, style, sector and even sub-sector bets; they can also take regional and country tilts and in some cases can make leveraged investments and take short positions. It is only natural, therefore, that the latest buzz surrounding ETFs is about the launch of a first official actively managed fund.
But for all the chatter, it has not happened yet, and it is not entirely clear when
it will. “Active ETFs have been a year away for years,” says David Haywood, director of alternative investment research at Financial Research (FRC), the Boston-based data company. “There is a lot going on and with all of the new entrants to market, one of them could get it done. But I honestly could not predict when an active ETF will make it to market.”
ETFs – first introduced by State Street in 1993 – have skyrocketed in popularity in recent years. Today, assets in ETFs total more than $336.9bn compared with $71bn in 2000. And just in the past year, there has been a significant rise in the number of ETFs, according to the Investment Company Institute, the industry body. As of July 2006, there were 268 ETFs, whereas in July 2005 there were 171 – a 57 per cent increase. In June alone there were 42 new ETF launches. To put that in perspective, the total number of ETF launches in 1996 was 17.
While many of these newly launched ETFs use indices that incorporate alternative weighting and quantitative strategies, none are technically considered actively managed. “People are just trying to do something that’s a little different,” says Dan Dolan, director of wealth management strategies for the Sector SPDRs Trust, which is managed by State Street. “There are only so many recognisable indices and once they’re taken, you’ve got to put a new spin on what you’re doing, you’ve to distinguish yourself from the competition.”
The result, arguably, is needless complexity and confusion. William Breen, a finance professor at Northwestern University’s Kellogg School of Management, says the field has been so complex that investors need to look at the contents of the funds, not just their label. For example, the difference in annual returns over the past five years of two ETFs tracking US small companies is 6 percentage points a year – and the better-performing fund has done it with only 70 per cent of the volatility. So, which index you chase can make a big difference.
Many ETFs are not as diversified as they seem, he says. “You can take too much specific risk by investing in concentrated indices. If you look at iShares’ Spain fund, 49 per cent of the portfolio is in the top three stocks.”
In sectoral ETFs, he says, it is not uncommon for the largest holding to account for more than 20 per cent of the fund. On these arguments, ETFs do not offer quite the passive diversification that many of their investors are looking for, and so launching an active ETF might make sense.
The biggest obstacle to active management in the ETF business is the transparency problem. At the moment, the Securities and Exchange Commission stipulates that ETFs must disclose their holdings on a daily basis, whereas traditional mutual funds are required to disclose their holdings every six months. This is not a problem for someone tracking an index. They are not buying and selling very often, and everyone in the market already knows the constituents of the index.
Active managers, however, do not want to reveal their holdings for fear of being front run by the market. The big concern is that observant hedge funds would notice when an ETF buys a particular stock and then start buying that stock on the basis that the ETF will continue to add the stock to its portfolio. This would in turn drive up the price the ETF pays.
The current disclosure rules would also enable rivals to easily copy each other’s trading strategies, says Brad Pope, director of strategy for Barclays Global Investors’ iShares. “Transparency has two main benefits: one is that on any given day investors know exactly what’s held in the portfolio and therefore have a better understanding of what they can expect; and two, it enables the market maker to better trade the product,” he says.
These concerns over transparency represent a huge hurdle for fund companies who 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 both the pent-up demand and the fact that there are very few ways to differentiate index funds – there will be a penalty for being first with active management.
“There is steep cost to being the first,” says Noel Archard, head of ETF product management at Vanguard. “From an operational point of view there is the question of how we satisfy the trading community’s needs for full transparency but also protect the shareholders. It means a lot of time and money spent to make the regulatory bodies comfortable.”
So far these hassles have been too great to overcome, which is why fund companies appear to be waiting for someone else to make the first move. Once that happens, others will probably follow. “Right now you have people poised in the wings waiting to see how that first one out of the gate goes,” Mr Archard says.
Of course there is another big question surrounding this issue: are actively managed ETFs even necessary?
As trading vehicles, ETFs already have some distinct advantages. For instance: unlike mutual funds – which set a price for shares once a day after the market closes – ETFs are priced like stocks and traded throughout the day. This allows investors to dash in and out of the market while also using stop orders – orders to buy or sell when a specified price is reached – and limit orders, to buy or sell a stock at or close to a particular price. Moreover, because ETFs trade like stocks, they can be sold short – meaning investors can bet an index will fall by selling borrowed shares, then buying them back when prices drop.
Active management could enhance these features, Mr Archard says. “From a conservative point of view, an active ETF would give you some interesting risk strategies – such as options. If you like a manager, you could go long, but you can also buy a put for when that particular manager’s style happens to fall out of favour. With a bad manager, you could even sell short,” he says.
On the other hand, introducing active management could diminish the attributes of ETFs that investors find so appealing, such as their low costs, total transparency and tax efficiency. Dan Culleton, lead ETF analyst at Morningstar, the fund data company, says he is especially concerned that active management would reduce ETFs’ tax advantages. Unlike mutual funds, ETFs do not need to sell their holdings to meet shareholder redemptions, helping to minimise capital gains distributions. “It’s possible that an active fund manager who is picking stocks would incur more turnover and have to realise more capital gains not recognised by ETFs in-kind redemption feature,” he says.
Active management could lessen the funds’ cost-effectiveness, too. “Management fees would be the big concern,” says Mr Culleton. “Ostensibly you’re getting the talent of the manager and his or her staff. Everyone thinks they deliver a lot of alpha and so they’re going to charge you what they think they’re worth. Already we’re seeing expense ratios creep up on certain ETFs that have launched recently because they ‘add value’.”
Mr Dolan, a self-described ETF purist, says active ETF management would lessen their appeal. “The beauty of the product gets diluted,” he says. “It’s like anything in the financial services world, when a product is popular and it works, the market gets flooded until it stops working. Look at what’s happened to hedge funds.”
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