Fund Spy

The Quest for the Holy Grail of ETFs Continues

Dan Culloton

Reports of the arrival of actively managed exchange-trade funds have been greatly exaggerated. Sure, there are some ETFs of recent vintage that come close, such as the PowerShares that track the quantitatively constructed Amex Intellidexes. Firms also have filed applications for active ETFs with the Securities and Exchange Commission, and it's a good bet there are others with their own plans out there, biding their time while someone else bears the expense and hassles of being the first one to brave regulatory review.

Don't expect to see a fully active ETF on an exchange near you any time soon, though. They still have too much to prove to regulators, money managers, and investors before they become widely available. In the four years since the SEC first sought comments on actively managed ETFs, we've often heard predictions of their imminent launch, but nothing has yet materialized. Even those involved in the development of what many in the industry consider the Holy Grail of products, concede it still could be a long time before the SEC decides whether to allow active ETFs.

Yet, someone eventually will figure out a way to offer actively managed ETFs. The market opportunity is simply too vast to ignore and ETFs have grown at a torrid pace on the backs of index funds. Most of the $8.6 trillion in conventional funds, however, is in actively managed offerings. The prospect of converting even a fraction of those assets to active ETFs is enough to make fund company and stock exchange executives drool. There is more than enough incentive for ETF sponsors to keep trying until they get it right.

Should you care when they do? After studying some of the more promising (or at least public) proposals, I can think of a couple attractions, but I'm still firmly in the skeptics camp. Here's why.

Under the Hood
Index ETFs, as they are currently structured, work because everyone involved knows exactly what is in their portfolios and how to value their shares throughout the day. Indeed, the current crop of ETFs publishes per share portfolio values every 15 seconds throughout the trading day. That allows the market makers who assemble the baskets of securities required to create ETF shares to hedge their positions. 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. Active fund managers, however, 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.

Let's look at a couple of the most widely discussed proposals for solving this conundrum. The American Stock Exchange, which launched the first ETF in 1993, has been working on a solution for several years. Instead of disclosing an actively managed portfolio's precise holdings, the AMEX plan would use quantitative models to construct a proxy portfolio that closely mimics the fund's risk characteristics. The proxy portfolio would be designed to give specialists and market makers enough information, including a intraday share value based on the proxy portfolio every 15 seconds, to hedge their trading positions without exposing the manager's trades. The proxy portfolio value won't exactly track the actual portfolio value, but AMEX argues the error would be small. Officials at the exchange also say the odds of other investors reverse engineering the actual portfolio from the proxy is infinitesimal.

For a more complicated approach, consider New Jersey-based Managed ETFs' proposal. The firm, which was cofounded by former AMEX and Nuveen Investments executive Gary Gastineau, plans to tell market participants each day what securities they need to compile creation or redemption baskets for its active ETFs, only it will hide its recent buys and sells until they are complete. If the fund is in the process of liquidating a position the stock or bond will stay in the creation/redemption basket at its original weight until the manager is done selling. If the offering is buying a holding it won't show up in the basket until the transaction is complete.

Managed ETFs also plans to give the market not one, but two intraday values for its portfolios. It will provide the precise value at 9:30 a.m. EST and update it on the hour from then until the market closes at 4 p.m. EST. The firm's funds also would reveal every 15 seconds a version of the precise portfolio value that has been modified by adding or subtracting a number drawn randomly from a disclosed probability distribution. The idea is to give market participants an idea of which way the portfolio value is trending between the hourly disclosures of the precise value.

Potential Benefits
Advocates say active ETF shareholders would enjoy many of the same benefits of index ETFs. Because only authorized participants would deal directly with the funds, managed ETFs would shed the administrative costs of maintaining individual investor accounts and thus have lower expense ratios than conventional actively managed funds. The funds will be able to use the in-kind redemption mechanism to avoid capital gains distributions, so they could be more tax efficient than regular mutual funds. And, of course, investors would be able to trade, short, and perhaps write options on actively managed ETFs all day, which gives them the flexibility to employ tax loss and risk control strategies they can't use with traditional funds (as well as the opportunity to rack up commission costs).

The most compelling argument in favor of active ETFs, though, is the protection they could provide from the trading of other shareholders. Traditional fund managers often have to hold cash or sell securities to pay off investors who redeem their shares. That can erode returns, especially if the manager would rather keep the fund fully invested. This isn't as big a problem with ETFs because investors buy and sell their shares from each other on the secondary market, so their trading has no significant effect on the portfolios' management. Managed ETFs plans to add another layer of protection by cutting off creation and redemption orders at 2:30 p.m. EST, even from authorized participants who deal directly with the fund.

Persistent Cons
It's far from clear active ETFs will live up to the hype, though. While they may be less expensive than old school mutual funds, they probably will be more expensive than index ETFs. Managed ETFs already has proposed creating ETF share classes with front- and back-end sales charges and 12b-1 fees.

It's also clear actively managed ETF portfolios will be less transparent than their index ETF counterparts; less transparency means wider bid/ask spreads and possibly larger premiums and discounts, which increase transaction costs. The opacity also might impair active offerings' tax efficiency. To answer these questions those pushing for active ETFs trot out a tired argument that traditional fund managers have often used to justify high fees: The offerings will make up for the higher costs and bigger spreads with superior performance. Most active fund managers fail to beat their benchmark indexes over the long term, though. The ETF format might help them eke out some extra performance via lower fees and reduced transaction costs, but it won't make them better investors.

There are a host of other issues. What happens if an actively managed ETF manager wants to close the fund to control its asset base? Will the ETF then act like a closed-end fund, which tends to trade at bigger premiums and discounts? What caliber of managers will have enough confidence in the proposed format to make their services available in an ETF? I could be wrong, but it seems doubtful there will be ETF versions of  American Funds Growth Fund of America (AGTHX) or  Selected American Shares (SLASX).

In the end actively managed ETFs may sacrifice too much of what has made index ETFs successful. Who wants more expensive, and less tax efficient and transparent, ETFs? Once actively managed ETFs arrive, they will bear the burden of proof to deliver what they promise before long-term investors can regard them as viable alternatives.