Bear Stearns (BSC) this week became the first company to file a full prospectus for an actively managed ETF. Its March 19th filing, first reported by Sam Mamudi in Fund Action (and later by Ian Salisbury in The Wall Street Journal), covers a money-market-like fund that will hold a variety of short-term fixed-income instruments, including Treasuries, municipal obligations, bank obligations, and mortgage-backed securities. The “Bear Stearns Current Yield Fund” will use active strategies in an attempt to deliver yields above and beyond the average money-market account.
If approved, the fund will trade will trade on the American Stock Exchange [AMEX] under the ticker symbol “YYY.” It will charge 28 basis points in expenses – higher than any fixed-income ETF currently on the market. But, of course, it will aim to more-than-compensate for those increased fees with its actively managed performance.
While a number of fund companies have made plans for actively managed equity ETFs – Firsthand Funds, Managed ETFs, etc. – none have gone so far as to file a prospectus. Those companies have instead petitioned the SEC for “exemptive relief”; they have asked the agency to waive or alter existing rules in such a way as to allow their actively managed ETF to list. No one knows for sure when or if the SEC will move on these requests, although many believe the space will heat up by the end of the year.
For now, Bear Stearns wins the laurels for being the first company with an active ETF prospectus on file. They’ve succeeded for good reason: the nature of the YYY fund sidesteps many of the traditional challenges of creating an active ETF. As such, it does not immediately herald a wave of actively managed ETFs. Nonetheless, for the active optimists among us, it’s progress can only be a good thing.
One of the biggest challenges to creating an actively managed ETF is the issue of disclosure. Active manager are loathe to tell people what they are buying, for fear that traders will “front-run” the fund and drive up the price of shares the manager is trying to buy.
That rubs up against the nature of ETFs. ETFs generally trade at fair value because authorized participants can always create new shares of the ETF and hedge against the underlying portfolio. If, for instance, the SPDRs ETF (AMEX: SPY) were to trade out-of-line with the value of the S&P 500 Index, arbitrageurs could buy the 500 stocks in the index and trade them in for shares of the ETF, profiting on any difference in value. Without full disclosure, this becomes more difficult.
The people working on with actively managed ETFs have come up with two methods to deal with this:
a) Full Disclosure: Simply reveal the portfolio and take your chances
b) Proxy Portfolio: Create and disclose a portfolio of securities with similar characteristics, allowing arbitrageurs to use this instead of the “real” one for arbitrage capabilities.
Needless to say, the SEC is more concerned with the “proxy” idea than with full-disclosure – while most active managers would prefer the proxy.
The Bear Stearns fund takes the easy way out, using the full disclosure approach. They are able to do that because YYY is a money-market-like fund. The truth of the money-market market is that there are hundreds of thousands of securities, and one can be swapped for another without too much difference. Short-term fixed-income managers don’t outperform the market by choosing good securities; they do so through careful cash management, and by positioning funds on different parts of the short-term yield curve. No one is worried about “front-running” in the ultra-short-term space, so one of the biggest issues with active ETFs simply disappears.
A related issue is one of creation and redemptions. As mentioned, the nature of ETFs is that “authorized participants” can create new shares by delivering the underlying portfolio to the fund company, and vice-versa. Without full disclosure (or with rapid turnover), it is impossible to deliver an accurate “basket” of the underlying shares. The Bear Stearns fund sidesteps this issue by allowing creations and redemptions in cash. After all, the fund holds “cash-like” instruments bought from a hugely liquid market. It matters little to the portfolio manager if they receive cash or certain mortgage-backed securities; in fact, it’s probably easier to get cash. There might be transaction costs associated with putting this cash to work, but it will be limited.
This is another feature that makes short-term funds uniquely suited to be the test case for active ETF management.
Where Do We Go From Here
For all the exciting headlines this fund will generate, it’s really not a huge leap forward for actively managed ETFs. It’s an important step, but it’s a baby step. Bear Stearns has leveraged the unique aspects of the money market area to develop an active ETF that sidesteps most of the major concerns associated with actively managed ETFs.
Will the SEC approve the fund? That remains to be seen. Will it deliver on performance? That remains to be seen too. The transaction costs associated with the cash redemption policy could be an issue; then again, most money market funds allow investors check-writing privileges, so the issues won’t be altogether different. (It’s worth noting that this is not a money-market fund; there is no tacit guarantee that it won’t lose value, and it will take on more risk than most money-market strategies.)
This will be Bear Stearns’ first ETF. Some have suggested that the active strategy could be applied to fixed-income funds of longer duration. That may be true, but the issues would be larger, as the cash-redemption feature would be called into question.
For now, they made a baby leap forward, and that’s interesting enough.