Actively-Managed ETFs: What’s the Big Deal?

In April, 2008, Chance Carson, President of Alpine Strategies, LLC in Colorado, interviewed Mr. Richard Ferri, author of the highly instructional book on ETF investing The ETF Book: All You Need to Know About Exchange Traded Funds, John Wiley & Sons, ©, 2007. One of the many topics covered in the interview was about the development of actively-managed ETFs. Here are some highlights from the interview.

Chance Carson: One of the difficult issues facing actively-managed ETFs is the SEC’s daily disclosure rule. Tell us more about that.

Richard Ferri: Open-end funds only have to report holdings four times per year, and by the time they report, the securities on the report list can be outdated. By contrast, actively-managed ETFs are required to publish their holdings each day. The SEC’s concern is that daily disclosure will lead to front-running by traders who try to get in front of an ETF manager’s trades, and profit from those trades. Powershares' solution was to impose a three-trade rule. The rule applies to PowerShares Active Alpha Multi-Cap Fund (NYSE: PQZ) and PowerShares UltraQ Portfolio (NYSE: PQY). In both funds, the fund manager, AER, uses quantitative methodology to choose 50 stocks. However, the fund manager is only able to trade three stocks per week, and those trades must take place on the last trading day of the week. The only thing the manager can do is to liquidate and buy three new securities in the fund per week; which is not the same active management we are familiar with in the open-end fund world.

Chance: What about PowerShares initial launch of its actively-managed bond fund, the PowerShares Active Low Duration Fund (NYSE: PLK) and the PowerShares Active Mega Cap Fund (NYSE: PMA)? Those are two ETFs that are not subject to the three trade rule. Are they going to have a problem with front-running?

Richard: Both of those funds are trading in securities that have very large daily trading volumes. PLK is composed of very liquid government and corporate bond offerings. PMA selects securities only from the Russell Top 200 and other “mega” cap stocks that have been screened for liquidity. Even though the SEC has allowed PowerShares to freely trade with these large stocks, they still have to disclose exactly what is in their portfolio daily, just like all the other ETFs. As long as only the largest and most liquid securities are being traded, the SEC believes that front-running will be mitigated to a point where it is not a factor.

Chance: How about tax efficiency for actively-managed ETFs, one of the most favorable features of ETFs?

Richard: I think you’ll eventually see there will still be some tax efficiencies with actively-managed ETFs, but not as much as with ETFs that follow an index. An ETF that follows an index has tax efficiency when you use the Authorized Participants to do a lot of trading for you in positions that leave the index. With actively-managed ETFs, the fund manager will be doing more selling of securities inside the fund. That will cause more taxable events in actively-managed ETFs than in ETFs that follow indexes.

Chance: It sounds like unless there is a dramatic change in the SEC daily disclosure rules, this whole idea of actively-managed ETFs will have some difficulty in popularity.

Richard: Daily disclosure is the number one issue with actively-managed ETFs. There are several proposals in front of the SEC to offer actively-managed ETFs that do not disclose positions daily. However, little progress seems to be occurring on those proposals. In fact, a couple of those proposals have been at the SEC for several years. I forecast that it will be some time, if ever, before any of those proposals are approved. That said, if or when one of those proposals do get SEC approval, I believe there will be a flood of new product launches.

Chance: Thanks for your help clarifying some of the mystery around actively-managed ETFs.

NOTE: There have been a number of actively-managed ETFs that have launched. Examples include PowerShares Active Alpha Multi-Cap (PQZ), Active AlphaQ (PQY), Active Low Duration (PLK), and Active Mega-Cap (PMA), and Bear Stearns Current Yield (YYY). This list may not include other newly-issued actively-managed ETFs.

Disclaimer: Mr. C. Chance Carson is a Registered Investment Advisor Associate and holds no positions in the ETFs mentioned in this article. The staff of Alpine Strategies, LLC holds no positions in the ETFs mentioned.