John Spence

SEC Reviewing Actively Managed ETFs

Not one of the currently 102 exchange-traded funds (ETFs) listed in the United States holding over $70 billion of assets in their coffers is actively traded. All are linked to equity benchmarks from the popular index providers such as Dow Jones, Russell, and Standard & Poor's.

Many firms are contemplating actively managed ETFs, however, and the Securities and Exchange Commission recently requested public comment in recognition of the industry's keen interest and likely investor demand. The most obvious stumbling block for an actively managed ETF is how it would disclose the contents of its portfolio, since active managers are loath to reveal their trades for fear of being front run by the market.

The dilemma is that intra-day continuous pricing and transparency are what keep the price of the existing ETFs in line with the net asset value (NAV) of the underlying portfolio. ETF shares are created and redeemed "in kind," with specialists creating new shares to meet demand or redeeming shares to quell supply on a daily basis. If the market maker is not keeping the price close to the NAV, arbitrageurs can step in and have thus far prevented significant premiums and discounts from arising in domestic ETFs.

In Germany, the Deutsche Brse has been trading what it calls actively managed ETFs for over a year. The underlying stocks are not disclosed and the NAV is not priced continuously. Instead, the fund company releases a NAV at the close of each trading day. So essentially, these "ETFs" trade shares during the day without a true measure of the NAV, which inevitably leads to wider premium/discount spreads. An interesting, if not dubious, feature of these active ETFs is that the German market makers are privy to additional information about the component stocks so they can more accurately price the funds.

Bruce Levine, head of new product development at Barclays Global Investors, admits it's hard to imagine the SEC, with its more stringent regulations, allowing an active ETF to play it so close to the vest here in the States. According to Levine, the allure of active ETFs is that investors could get in and out of the fund throughout the trading day, the funds could be held in a brokerage account, and that fees would be lowered for those who believe active managers can beat the market. However, Levine notes it's not exactly clear yet how the SEC will strike a compromise and figure out a way for an active ETF to have the necessary transparency without hindering its ability to maximize returns for shareholders.

"Above all, an investor or financial planner must have confidence that the product he's buying actually is what he thinks he's buying," said Levine. Another primary concern voiced by the SEC regarding the prospect of actively managed ETFs is that increased turnover will likely negate the low expenses and tax efficiency that are the main ETF selling points for individual investors.

Interestingly, the SEC's request for public comment has also reignited the long-standing debate over how frequently active managers should disclose their portfolios. Active managers balk at the idea of revealing their stock holdings for fear that copycats will "free ride" their proprietary research or front run their trades. Mutual funds are currently required to release their holdings only twice a year.

Morningstar senior fund analyst Scott Cooley pointed out an interesting contradiction that arises when discussing the possibility of active ETFs. "On the one hand, several firms have apparently filed to offer active ETFs whose functioning would seemingly require a great deal of portfolio transparency," says the pragmatic Cooley. "On the other hand, the industry trade group, the Investment Company Institute (ICI), seemingly believes the world would come to an end if funds had to produce quarterly portfolios with a two-month lag."

The front running issue may be a moot point if, as some industry observers believe, there won't be much demand for active ETFs. Yet another obstacle for active ETFs is how the market maker will hedge the portfolio. For example, ProFunds announced its plans to launch an ETF as a separate share class of its existing leveraged funds, which use options and futures. One wonders how a market maker will be able to control risk in a portfolio that uses derivatives and the like. Finally, futures and options contracts are not eligible for in-kind redemptions, which is another glaring problem. Therefore, the ProFunds ETFs would most likely use a cash creation basket, which are currently used by the Barclays iShares based on emerging market indexes. The portfolio manager could then use the cash to purchase derivatives contracts on the open markets (the opposite for redemptions).

There is a higher creation fee for cash that would remove the in-kind transaction tax benefits of ETFs. For this reason, ETF cash creation is used when it is the only option, as in emerging markets or potential actively managed funds. Obviously, the idea of actively managed ETFs raises some interesting, if not esoteric, issues about the inner workings of these relatively new funds. However, passive investors mindful of ETF brokerage commissions should be content with the growing array of cheap ETFs firmly hitched to equity indexes.