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By Matthew Hougan

The real question with these new active ETFs is not active vs. passive. It is, "Does front-running matter?"

As Jim Wiandt recently mentioned, if you use the traditional definition of active management ---the pursuit of alpha --- we've had active ETFs since May 1, 2003. That's when PowerShares launched its first two ETFs:

  • PowerShares Dynamic Market Portfolio (AMEX: PWC)
  • PowerShares Dynamic OTC Portfolio (AMEX: PWO)

Both are quant-based funds that try to outperform the market by selecting companies based on "a variety of investment merit criteria, including fundamental growth, stock valuation, investment timeliness and risk factors." [PowerShares Fact Sheet.]

PWC uses a quantitative methodology to choose 100 stocks from among the 2,000 largest U.S. equities. The fund generally aims to outperform the S&P 500.

PWO uses a quantitative methodology to choose100 stocks from among the 1,000 largest stocks listed on the NASDAQ Stock Market. PWO generally aims to outperform the Nasdaq-100.

The important thing to understand is that these funds have been big winners, both for PowerShares and for investors. PWC's index has crushed its benchmark since inception, delivering 16.51% compound annual returns through year-end 2007 vs. 12.64% for the S&P 500. PWO's index has drawn even, posting an identical return to the Nasdaq-100 Index at 14.78% per year.

Between them, the two ETFs have about $700 million in assets.

Direct Competitors To PWC/PWO

The first clue about the real purpose of these new active ETFs is that two of them are direct competitors to the very successful PWC and PWO.

The PowerShares Active Alpha Multi Cap Fund (NYSE: PQZ) uses a quantitative methodology to choose 50 stocks from among the 2,000 largest stocks in the U.S.

Sounds familiar?

The PowerShares UltraQ Portfolio (NYSE: PQY) selects 50 of the 100 largest NASDAQ-listed securities using a similar quant-based methodology.

Again: Sound familiar?

There are differences between PQZ/PQY and PWC/PWO. PWC/PWO track Intellidex indexes designed by the American Stock Exchange, and PQZ/PQY track quant-based strategies designed by AER Advisors. The new active ETFs hold half as many stocks (50 vs. 100) as the established ETFs, and they equal-weight those stocks compared to the two-tiered weighting scheme favored by PWC/PWO.

But really, these are very similar products.

So why would PowerShares introduce new funds that compete head-to-head with its "franchise" products?

The answer is: one day.

One Day

PWC and PWO are index-based funds. Every morning, the American Stock Exchange publishes a list of components for the underlying indexes. The funds match those indexes exactly.

When an index rebalances, changes to the portfolio are published in the index before the ETFs have had a chance to trade. The index is published in the morning ... the ETFs trades after the opening bell.

The worry is that hedge funds and other "fast traders" "front-run" changes in the fund. They know that the ETF has to buy X shares of stock A and sell X shares of stock B, so they buy Stock A before the fund buys and sell stock B before the fund sells. The expectation is that the ETF's trades will boost (or drive down) the price of the stocks. It's the "S&P effect"---where stocks being added to the S&P 500 rise in anticipation of buying by the index funds---but on a much smaller scale.

PQZ/PQY are different. When the underlying manager (AER Advisors) decides to make a trade in these new funds, it simply makes those trades. There's no index involved, and no one knows about the trades before hand, so no one can front-run the move. The "new portfolio" is published the next business day.

That one-day lag eliminates front-running and is what these funds are really all about.

Where We Go From Here

Will investors buy into this idea? Who knows?

My guess is that PowerShares has studied this phenomenon and believes that front-running is costing its index funds money. Maybe not a lot, but some: 10, 20, 50 basis points or more per year.

It will likely be some time before we know if the one-day lag really gives a performance boost to the new funds. And anyway, the methodological differences between PQZ/PQY and PWC/PWO are too different to make an apples-to-apples comparison easy.

But that's what PowerShares is going after, I think, and that is why these new funds are important.

Source: Active ETFs: It's All About Front-Running