A Surprise Entry in the Race for Actively Managed ETFs

Vanguard has entered the race to launch the first actively managed exchange-traded fund. I think actively managed ETFs still have a lot to prove, but when a name like Vanguard enters the fray, it attracts attention and is worth examining.

Surprise, Surprise
Vanguard's active ETF proposal may surprise some. After all, Vanguard founder John C. Bogle has been a vocal critic of ETFs. But Bogle's successor, John J. Brennan, and his staff, many of whom also worked under Bogle, have embraced ETFs as another way to distribute mutual funds. The family is now the third-largest ETF firm in the business with 32 offerings and $29 billion in assets.

In this light, it makes sense that Vanguard would be in the thick of the quest to launch an active ETF, which has been the holy grail of the ETF industry. Though the firm most likely has been working on the issue for a long time, it formally entered the fray in the first quarter by filing an application with the Securities and Exchange Commission that seeks permission to launch an exchange-traded share class for its Vanguard Inflation Protected Securities VIPSX. A lot of things still have to happen before an ETF tracking this fund hits the market, though. This filing seeks only exemptions from the Investment Company Act of 1940 that would allow Vanguard to issue an Inflation-Protected Securities ETF. Assuming the SEC grants those exemptions, the family would have to seek approval for the actual ETF later.

Furthermore, the SEC hasn't been in a hurry to approve previous applications for actively managed ETFs. The SEC has been studying actively managed ETFs for years and in previous concept releases on the subject has questioned if actively managed ETFs will give market makers enough information to assemble the baskets of securities they need ensure liquid markets for ETF shares. Most existing ETFs publish their portfolios every day and their per share values every 15 seconds throughout the day. If the specialists didn't have that information or received it less frequently, they might not be as willing to create or redeem ETF shares, which could lead the ETFs to trade at wider bid/ask spreads and bigger discounts or premiums to their net asset values.

The biggest impediment to active ETFs, though, is active fund managers themselves. Many active managers often balk at disclosing their portfolios more than the four times per year required by the SEC. They fear doing so would tip off other investors about the funds' latest moves. This, they argue, would allow other traders to "free ride" on the funds' research and ideas, or "front run" the managers' trades. For example, traders could monitor an active ETF's daily creation/redemption basket for signs that the fund is building or exiting a position and then try to buy or sell ahead of the fund, forcing the manager to purchase at higher prices and sell at lower prices than he or she would have liked and adversely affect performance.

The Vanguard Way
To ameliorate these concerns, Vanguard in its application points to the "plain vanilla" flavor of the Inflation-Protected Securities fund, as well as its considerable skill and experience managing quantitative portfolios. Inflation-Protected Securities is not a complicated fund. It keeps nearly all of its money in highly liquid U.S. Treasuries, whose principal values are adjusted for changes in the consumer price index, and usually owns about 20 securities. Though the fund's duration, yield curve stance, and security selection may differ from that of its benchmark, the Lehman Brothers Treasury Inflation Notes Index, the offering is very indexlike. Due to the liquidity of inflation indexed Treasuries; front-running isn't much of an issue.PAGEBREAK

Nevertheless, Vanguard doesn't plan to reveal its actual portfolio to the market every day like an index ETF. Rather it will use its own computer model to create a sample of the portfolio that matches the overall fund duration, yield curve positioning, and other characteristics of the fund without giving away its precise contents. The sample would include 50% to 75% of the securities in the portfolio and should track the performance of the actual fund within 3 basis points, or hundredths of a percent at least two thirds of the time, Vanguard says in its application. Vanguard, in fact, also said in the application that in both backward- and forward-looking tests of its technique, the proxy portfolio's performance differed from that of the actual portfolio by less than 3 basis points. That should give market makers reliable enough information to keep premiums/discounts and bid/ask spreads for the proposed ETF narrow, Vanguard contends.

The computer model Vanguard plans to use to create the baskets is a slightly modified version of the programs the family uses to track large indexes such as the Lehman Brothers Aggregate Bond Index at Vanguard Total Bond Market VBMFX and the MSCI U.S. Broad Market Index at Vanguard Total Stock Market Index VTSMX. Those are conventional funds that do not have to reveal their portfolios to the market every day, but they have solid records of tracking their benchmarks. Vanguard argues that regulators, investors, and market makers should expect the same exactitude when it constructs the proxy portfolio.

Ready for Prime Time?
I have mixed feelings about the proposed ETF. Like the bond ETFs Vanguard rolled out last month, Vanguard's TIPS ETF should undercut the only other current TIPS option, iShares Lehman TIPS Bond TIP, on price. And if it succeeds in serving up the consistently above-average results that the traditional share class of Vanguard Inflation Protected Securities has so far, it should be a solid option. Still, actively managed ETFs are a whole new animal. Even with Vanguard's quantitative expertise, there's no guarantee they won't trade at wider bid/ask spreads and premiums/discounts than index ETFs. Personally, I'd like to see how Vanguard's proposed active ETF behaves in the real world (assuming regulators approve it and it makes it there) before getting excited about it.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

Dan Culloton is a senior analyst with Morningstar.