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 . 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 , 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 , which provides exposure to 95% of the world's stock markets, and  AdvisorShares Cambria Global Tactical ETF , 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.

Who is issuing active ETFs?
Right now, the pool of active ETF providers is fairly small. WisdomTree issues foreign currency and local debt active ETFs, while AdvisorShares offers a suite of very narrowly defined, active ETFs focused on given strategies that are implemented by various subadvisor partners. In addition to MINT, PIMCO currently has several other active ETFs available--mostly in the municipal bond space--and PowerShares has a set of active ETFs that have attracted a minimal amount of assets.

In fact, two of those funds, PowerShares Active Alpha Multi-Cap  and PowerShares Active AlphaQ , are scheduled to liquidate at the end of September. Rounding out the list are iShares, which currently issues one fairly successful alternative ETF, iShares Diversified Alternatives Trust , Columbia, which recently acquired and renamed the active ETFs that the now-defunct Grail Advisors had created, and Russell Investments, which entered the active ETF space by buying U.S. One and rebranding that firm's lone ETF as the Russell Equity ETF . We expect Russell to use U.S. One's existing regulatory permission to issue more active ETFs in the future.

Who's next? Who isn't?
A raft of large financial-services firms have filed for SEC approval to create active ETFs. Firms with applications pending for so-called" exemptive relief" to be permitted to issue active ETFs include State Street STT, ALPS, John Hancock,  Eaton Vance ,  Northern Trust (NTRS),  Goldman Sachs (GS),  Janus ,  T. Rowe Price (TROW),  Legg Mason , Neuberger Berman,  AllianceBernstein (AB),  J.P. Morgan Chase  (JPM), Huntington Asset Advisors, Arrow Investment Advisers, and Federated Investment Management.

Meanwhile, notable large money management firms that still have not filed for permission to issue active ETFs include Vanguard, Fidelity, American Funds, Franklin Templeton, Oppenheimer, DFA, and Dodge & Cox.

Why haven't active ETF assets grown more?
It's reasonable to ask why active ETF assets largely have remained stalled thus more. The answer hinges in part on the lengthy amount of time that it takes for firms to secure exemptive relief to issue active ETFs, but even more, it involves current active ETFs' sheer lack of a track record. Until active ETFs establish a three-year track record, we do not expect many advisors to steer investors to them. And as we sit here today, only a handful of active ETFs--solely some of the ones issued by PowerShares and WisdomTree--have even reached their three-year anniversaries. As such, it's less likely that active ETF assets will grow rapidly until customary track records are established.

However, as you'll see below, there is one example of a proposed active ETF that should gather a large number of assets right out of the gate.

PIMCO Total Return: A Case Study Lies Ahead
We hold the view that nothing less than the future of asset management is riding on the success or failure of PIMCO's proposed PIMCO Total Return ETF. The world's largest bond fund is the mutual fund  PIMCO Total Return Fund (PTRRX). Priced at 0.55%, the proposed ETF version would be slightly more expensive than the mutual fund version's institutional share class (0.46%) and would be far cheaper than the A shares (0.85%).

In theory, the proposed active ETF should attract a significant amount of assets. Morningstar long has called for PIMCO and its guru Bill Gross--who has managed PIMCO Total Return since inception and along with his team received Morningstar's Fixed-Income Manager of the Year honors in 1998, 2000, and 2007--to create an ETF version of the massive PIMCO Total Return. Gross' track record is unsurpassed, and he may well be the single greatest money manager in history. Such a move would give investors more options, and at a lower fee, it would be a win-win for everyone involved. And the transparency issues that we have mentioned above couldn't be much of a hindrance--after all PIMCO is so big that every trading desk out there already knows when the firm is buying and selling.

If the ETF version of PIMCO Total Return succeeds, we expect to see far more big-name managers taking the plunge into active ETFs.

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