Active ETFs: A State of the Union

As exchange-traded funds have exploded in popularity among investors, a small corner of the ETF world--actively managed ETFs--continues to command outsize attention from investment companies but less investor interest thus far.

Active ETFs do not passively follow an index and instead employ actual portfolio managers who either use rules-based strategies or make portfolio calls based on a stated qualitative strategy.

At present, just $5 billion of the current $1 trillion-plus that is invested in ETFs is invested in actively managed funds. Additionally, well more than half of that $5 billion is soaked up by just three ETFs--PIMCO Enhanced Short Maturity Strategy ETF MINT, WisdomTree Emerging Markets Local Debt ELD, and WisdomTree Dreyfus Chinese Yuan CYB. In fact, equity-based actively managed ETFs make up a fraction of that $5 billion--just $83 million or so.

Clearly, then, the hype over active ETFs has not yet been matched by asset flows. However, for those who are drawn to the benefits of the ETF structure--their tax efficiency, their greater transparency than open-end mutual funds, their generally lower costs than traditional mutual funds, and the ability to trade them all day long--active ETFs are likely to represent an attractive option for investors in the future, as large money managers roll out more and more strategies in the active-ETF wrapper. And given how many major investment managers--including traditional open-end mutual firms--have filed for regulatory permission to issue active ETFs, we unquestionably will see more such products issued in the months (and years) to come.

What's more, a sea change may well be ahead for the entire fund industry, with the blockbuster announcement several months ago of by PIMCO that it intends to launch an actively managed ETF version of its massively popular Total Return strategy. Until now, few name-brand mutual-fund managers have ventured into active ETFs. All that changed in April, when PIMCO filed to launch the actively managed PIMCO Total Return ETF TRXT, to be managed by firm founder Bill Gross. The move demonstrates that there is nothing hindering most active strategies from being issued as ETFs, and it also suggests that other big-name managers can be expected to throw their hats in the active-ETF ring soon.

What active-ETF strategies are investors currently using?
Up to now, active ETFs have developed the most traction with investors in the fixed-income, money markets, and global macro arenas. Short-maturity debt ETFs and foreign local-debt funds far and away are the largest actively managed ETFs out there right now. Other active strategies that have begun gaining investor attention include fund-of-funds ETFs like Russell Equity ETF ONEF, which provides exposure to 95% of the world's stock markets, and AdvisorShares Cambria Global Tactical ETF GTAA, which holds ETFs and employs a long-term, trend-following strategy with strict, rules-based and systematic risk management controls to remove behavioral biases from investment decision-making and limit any downside.

Transparency fears: Front-running, shadowing
The notion of full, daily transparency of an ETF's holdings--as is customary in the ETF world--has been a sticking point for traditional mutual fund managers in their resistance to venturing into the active-ETF space. Managers typically cite two fears: investors "front-running" their decisions, or trading in advance of them--presumably at a more favorable price--and investors "shadowing" them, or making identical portfolio moves on their own, without actually investing in the ETF.

We have found neither argument to be especially persuasive. We view front-running to be a bit of a straw man argument because most mutual funds already are at monthly disclosure, and front-running already is going on anyhow in the marketplace, in the form of flash trading and high-frequency traders. We also consider shadowing to be both presumptuous and time-consuming on the part of investors.

Even so, some managers are aiming to mitigate this problem by proposing to issue nontransparent ETFs. Earlier this month, iShares' parent firm BlackRock BLK submitted regulatory paperwork seeking approval to create a broad range of actively managed ETFs that would not divulge their holdings each day. Instead, BlackRock and its partner, Spruce ETF Trust, would seek to provide their holdings on a monthly or once-every-three-months basis, as traditional open-end mutual funds do. The SEC has not ruled on the proposal yet.PAGEBREAK