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ActiveETFs | InFocus spoke with David O’Leary, who is the Chief Investment Officer for AER Advisors. AER is the portfolio manager behind two actively-managed ETFs from PowerShares which were one of the first Active ETFs to be launched in the US in 2008. The first is the Active AlphaQ Fund (NYSE:PQY) and the second is the Active Alpha Multi Cap Fund (NYSE:PQZ). David speakes to us about Active ETFs managed by AER Advisors, whether the transparency requirements of Active ETFs affect day-to-day management and what it’ll take for Active ETFs to take off.

Shishir Nigam – ActiveETFs | InFocus: Tell us a little about yourself and how AER Advisors entered the ETF space?

David O’Leary – AER Advisors: Well, I started in the investment business in 1973 and worked as an analyst for a bank and then managed money in the late 70s, early 80s, and then worked on the sell side of the street with a company called Fox-Pitt Kelton. And then I ended up at Fidelity in the early 1990s and developed a research capability, proprietary research, that I thought was pretty valuable. I left there in 1994 and started a company called Alpha Equity Research and we began to offer institutional research to mutual funds, hedge funds and pension funds.

In the early 2001-2002, we decided that our research was a good fit with ETFs and in 2003 we started the process of filing the first application for active exchange-traded funds with the SEC. Using our proprietary research, we started an affiliate company called AER Advisors and went through that process for about 5 years and then in late 2007, we got word that we were going to be approved. In early 2008, we realized we needed a lot of marketing help, so we decided to sell the first exemptive application for active equity ETFs to PowerShares and we became the sub-advisor for the first two that were launched – the AlphaQ Fund and the Alpha Multi-Cap. We’re coming up on the 3rd anniversary of the launch of those two funds.

When worked on the application, we had the idea of coming with a whole family of funds and we have about 75 portfolio strategies that we have trademarked. Unfortunately, PowerShares sold out to Invesco. Invesco has decided not to really utilize the application to its fullest. PowerShares is more concentrating on doing index products using S&P indices. 3-4 months ago, they came out with a series of small-cap index products and in the last couple of days they announced another 5 or 6 S&P index products. So they really haven’t utilized the active application the way we had hoped. But we’re still sub-advising the two funds and we are talking to other mutual fund companies interested in getting into the business because we do have this capability to do a lot of different products.

Shishir: As the portfolio manager behind the very first group of actively-managed ETFs in the US, what challenges did you face in bringing these products to market?

David: The launch of the products was actually pretty smooth. We launched on NYSE Arca and in the first couple of months we started to put on quite a bit of assets – I think at one point, the two funds were up to about $30 million in assets. And then the bear market hit and the funds dropped significantly – I think they dropped about 50% from their peaks – and obviously, the desire to own equity product by the public and by institutions dried up. And then because of the market decline, PowerShares never really got the marketing of Active ETFs going, they never really pushed them in advertising. So the whole idea kind of died on the vine. Also in that period, the SEC approved the ProShares and Direxion products and I think a lot of the buyers of ETFs that might have bought our products are fooling around with these aggressive, leveraged ETFs and its muddied the waters. You’ve also had a lot of new entrants into the business although we do have the largest active equity ETF which is the PQY, which has about $25 million of assets in it. It has very good performance and really should be a lot larger than it is.

In terms of the administration, the ETF products – the structure of it – works wonderfully in terms of portfolio management and the price of the ETF trades very close to the net asset value. So the whole arbitrage mechanism has worked great – very satisfied with that, very satisfied with the liquidity, very satisfied with the PowerShares platform and the website. We send them a notice of the changes and they execute them off their trading desk, which has worked out extremely well. I would say this has worked exactly the way we had hoped and the only disappointment we have is that we don’t have a lot more products on the market.

Shishir: The Active AlphaQ Fund (PQY) has gotten some positive attention as being one of the few Active ETFs that has been able to outperform its benchmark in both up and down markets. Could you describe the fund’s investment strategy and what has helped its success?

David: The PQY invests in the 50 highest rated – using our proprietary research – NASDAQ 100 stocks. Every week, we screen and take the 100 largest NASDAQ traded stocks by market cap and we use that as the universe to pick 50. Unfortunately, the good and bad news is that the benchmark, the NASDAQ 100 – 20% of that is Apple. We’re limited to a 3% maximum in any one stock. So as an example, in the last year we were up 13-14% and we’re beating the NASDAQ 100. If you limited Apple to 3% of the NASDAQ 100, it’s only up 4-5% this year. So, if the NASDAQ 100 used the same rule that we do for the maximum weighting in any one stock, we’d be about 10% ahead of the benchmark. So Apple, because it’s done so well, in the last couple of years we’ve outperformed the NASDAQ 100 even with Apple and I think the underlying performance has been quite good.

On a weekly basis, we just screen out those 100 stocks and when we started out we took the 50 highest ranked stocks and then every week if something drops below a 60% ratings – which in our proprietary rating is the difference between a buy and a hold – if there’s another stock within that universe that has a higher NOW rank, we drop the one that has come out of the universe and we put in another stock. In that fund, the turnover is probably running around a 100%, maybe a little bit less in the last 6 months. It’s been performing well and we haven’t had to make a lot of changes.

Shishir: So the underlying proprietary strategy that we’re talking about, is this something that’s more fundamentally driven, more momentum driven or a combination?

David: About 60% of the weighting is related to actual money flow in the individual company. We’re measuring up volume minus down volume and looking at it relative to the float of the individual names. We want to stay in companies that have buy pressure and avoid companies that have a lot of sellers in them. And about 40% of the weighting that we put on it is related to the fundamentals of the company – sales growth, profit margins. We don’t do any forecasting, we use consensus earnings and we’re looking for companies that have the highest growth, highest profitability and lowest price/earnings ratio. And so the combination of the money flow plus the fundamental part of it is how we come up with the rating on each individual company.

Shishir: Many traditional mutual fund managers see actively-managed ETFs as the start of a race to the bottom for fee levels in active funds – similar to what they have witnessed in the index space. Why did AER Advisors decide to package their strategy as an Active ETF?

David: Since we were in the research business and didn’t have any legacy mutual fund business to worry about, we thought the fees available on Active ETFs – somewhere around 75-85 basis points – was pretty attractive, given the fact that the cost of administering the fund was relatively low. You basically get the same investment management fee on an Active ETF that you would on a mutual fund but you don’t have a lot of the expenses associated with the mutual fund.

The direct sale of equity mutual funds really has declined very significantly in the last 4-5 years and, with the exception of Vanguard, most of the assets for equity shops are coming from load-based funds, many of which have 6% loads and 2% fees and back-end loads, short-term trading fees. Sometimes when you buy an equity mutual fund, you pay 8 or 9% in fees in the first year and I just think that’s a very unattractive business over time. That’s the attraction of the Active ETF business – that you can get an equivalent professional management, diversified Active ETF that’s equivalent to an equity mutual fund, get all the upside and pay a lot less in fees than you would. But the mutual fund industry’s problem is, again with the exception of Vanguard, they only generate assets by paying out huge fees which really are to the detriment of the customer. That’s one of the reasons why there are several mutual fund families that are talking to us about doing Active ETFs as they realize that over time the SEC could take away the 12b-1 fee, they could put more limitations on front-end loads and the more they do that the more they’ll cut into the profitability of the equity mutual fund product. So I think you’ve seen a lot of the major mutual fund families moving aggressively to filing applications for Active ETFs. A lot of them really don’t have the research capability that we do to do a lot of different products and so they may be limited to one or two or three.

Our approach is, sort of like the Van Eck approach, where you pick certain spots and get a universe – as an example, solar stocks. We could do an active solar ETF that would use the underlying index ETF as the universe and pick maybe 20-25 stocks within that universe. So we could do a lot of different specialty active ETFs, as opposed to a large-cap growth, a large-cap value, a small-cap growth etc. The big mutual fund companies tend to do the style-box approach and we don’t do that. We’re going after niches.

But I do think one of the reasons that Active ETFs have not taken off in a big way is there are many equity mutual fund families that feel the ETF product is a threat to their fee base. And so they’re continuing to push product through their broker-sold, load part of the business and hoping that the Active ETF business doesn’t take off. It will take off, it’s just a matter of time.

Shishir: Having managed an active portfolio with daily transparency for 2.5 years now, does that level of transparency lead to fears of your strategies being copied?

David: The potential for that always exists. However, I do think one of the main attractions of ETFs is that an individual investor or an institution, especially the algorithmic traders, can decide what part of the market they want to be in and do one trade that has high liquidity as opposed to doing 50 trades to replicate the underlying portfolio. So on one hand, there is a risk that somebody could buy the same stock and not bother buying the ETF. On the other hand, with one trade you buy a whole basket of stocks and for the amount of fees that are being charged versus the brokerage commissions you’d have to pay to buy the whole 50 stocks, I think many people would rather have the convenience of buying the individual ETF. I have not heard of anybody that’s trying to replicate our existing ETFs and I know people look for the changes we make. We email the changes to PowerShares during the day and PowerShares executes the trades on market on close. We don’t trade during the day, so whatever the investor sees at the end of the day – if they went in tonight at 6 o’clock let’s say, whenever PowerShares updates the website – they’re getting the portfolio that will be traded at the beginning of the day tomorrow. And it’s worked out extremely well. I was concerned about the transparency issue but having been managing it for a couple of years now, I really am not concerned about it at all. It’s kind of like the game people try to play with changes to the S&P 500 or changes to the Russell 2000 – they try to guess what they are.

I think the real attraction of the ETF product is somebody can say I want to buy $100,000 of this product, do one trade and own 50 stocks. You go to a place like Fidelity or other brokers, you can do one trade for $7.95 and own 50 stocks. So the convenience and liquidity of the ETF I think is the main attraction. In addition to that, to the extent that we do a good job picking the stocks and the fund performs well, then the buyer can focus more on creating a portfolio of ETFs that fulfills their needs rather than trying to figure out what stocks they want to own. The volatility of individual companies I think is more brutal today than it’s ever been. When somebody reports bad earnings, the stock is down 15% in a heartbeat and so an individual investor who might be fooling around with 5 or 10 or 15 stocks runs of the risk of owning and taking one of those home.

The other side of that is that one of the concerns about the transparency issues, is that if a manager might like to trade during the day, the market makers don’t really know what the value of the portfolio is adjusting for those trades because they are not reported until night time. In our case, we’re doing market on close and I’ve found that small changes in the portfolio are much better than continually trading during the day. Once the portfolio is in place, we make very small adjustments to the names that we own and in most cases, if something goes wrong, the stock is down so fast that you can’t make changes anyway. Even if you were trading during the day, the price changes so fast that it’s really almost a waste of time. The work that I’ve done suggests that it’s almost a coin flip, whether trading market on close impacts the performance positively or negatively, versus trading during the day. So I really don’t think it’s a big issue.

Shishir: You said most of the trading is done at market on close (MOC) for you fund. Does that result in greater market impact, because you’re trying to compress all your trades and finish all your trades by the end of the day?

David: We’re doing market on close, so we get whatever the closing price is. The advantage of that is the market maker doesn’t have a lot price risk with changes during the day because if the portfolio makes a change during the day and the market maker doesn’t know about it until 6 o’clock and it blows up, the market maker has exposure to the extent they’re carrying inventory. Under our system, it’s included in the final pricing of the product, so there might be risk the next day in adjusting but at least there’s not the front-running of the market maker. We don’t do that at all.

Shishir: What do you think it will take for PowerShares’ actively-managed ETFs and Active ETFs in general to start gaining greater traction amongst investors?

David: I think it just takes promotion. I’ll give you a perfect example. Putnam, a year or so ago, came out with a family of absolute return funds and Bob Reynolds went on, did a lot of advertising, came on and talked about it on CNBC and Bloomberg. The press, if you read the press reports, they didn’t believe it was a good idea and it wouldn’t work. Putnam has taken in $2 billion of assets on those absolute return funds. They’ve been very very successful, even though they’re load products. They kind of broke new ground in offering absolute return funds to the public. That’s what Active ETFs need – they need somebody like a Bob Reynolds at Putnam who has a face, who has the ability to project into the public, who can go onto the shows and have articles written and have the public relations behind him. And it also needs to have – in the case of absolute return, they had 4 products, there was a 1% over T-bills up to a 7% over T-bills. The same thing needs to happen with Active ETFs, you need to have a family of products, 10 or 12 or 20 products. Then you can come out and say this covers most of the major niche parts of a person’s portfolio and we as a major mutual fund company have put our capital up and our brand up and we think this is a great idea. That’s the sort of promotion that’s not occurring right now.

Shishir: That’s fantastic, thanks a lot for chatting with us David. It was good having you.

David: Very good.

Disclosure: No positions

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Source: Mutual Fund Companies Hoping Active ETFs Don’t Take Off – David O’Leary