3 Hurdles That Persist for Active ETFs

by: Shishir Nigam

Actively-managed ETFs are now close to completing the third year of their existence. The oldest active ETFs on the market, a set of four funds that Invesco PowerShares launched in April 2008, will reach their third anniversary on April 11, 2011.

Growth within the active ETF space has been solid, but most observers would agree that it hasn’t been spectacular. Active ETFs in the U.S. had combined assets of just $2.1 billion at the end of June 2010, and that number had grown by more than 65% to $3.5 billion at the end of Feb. 2011. Of course, large percentage increases don’t mean much when the absolute sums we are talking about are so small. Active ETF assets are still only a drop in the ocean that is the trillion-dollar U.S. ETF market.

There are some definite hurdles that continue to hinder the active ETF space and prevent the sort of exponential asset growth that has become commonplace in other ETF segments. Some of these are hurdles that are faced by issuers; others are faced by investors; and there are some that neither issuers nor investors can do anything about.

Hurdle #1: The SEC

As you might have guessed, the hurdle that no one can really do anything about comes from a regulatory source. In order to launch actively-managed ETFs for the first time, fund companies need to file an application with the SEC requesting exemptive relief necessary to create an ETF. Once that relief has been granted, the issuer can then file a prospectus for the specific planned ETF and move ahead with product launches under the granted relief order.

There has been no lack of exemptive relief applications filed with the SEC for the launch of actively-managed ETFs. Numerous large fund managers -- including the likes of Eaton Vance, J.P. Morgan (NYSE:JPM), Legg Mason (NYSE:LM), T. Rowe Price (NASDAQ:TROW) and others -- have active applications with the SEC for proposed active ETFs. However, in early 2010, the SEC launched a review of derivatives usage within ETFs and announced that all exemptive relief applications for active ETFs will be put on hold while this review is conducted.

This effective freeze set back product developments for many of these issuers by many months, if not years. A case in point is Van Eck, which was finally granted relief by the SEC in Nov. 2010 after waiting a whole two years, having first put in its exemptive relief application in Nov. 2008. Many firms started removing derivative usage from their planned funds to avoid trouble with the SEC, while others, such as Russell, took a more aggressive approach by acquiring a company that had already been granted relief.

According to IndexUniverse, the last word on the progress of this investigation came in the summer of 2010, when the SEC voiced concern to the IFIC regarding the generic nature of derivative disclosures in fund prospectuses. When the review finishes is anyone’s guess, but the investigation has definitely created a regulatory overhang over the active ETF space -- and that is definitely not helping product development plans.

Hurdle #2: Transparency Requirements

Transparency has traditionally been considered an advantage when looking at index ETFs versus mutual funds. However, when that transparency requirement was extended out to active ETFs, it became a whole new issue.

Active ETFs in the U.S. are required to disclose their complete holdings with a one-day lag. This means that the general public will have knowledge each morning of every single security that the portfolio held, as of the prior day’s close. So you could say that the disclosure is not “real-time,” but it’s close enough to give active managers the jitters. There are some active managers behind active ETFs who are perfectly comfortable with the transparency requirements, as David O’Leary – the portfolio manager behind the oldest active ETF – mentioned to us in this interview. However, there are others who firmly believe that the high level of transparency is deterring some active managers from running active ETFs.

There are two key concerns when it comes to transparency. First off, active managers who are used to making quarterly disclosures when running mutual funds find it hard to digest why they should give away their alpha-generating strategies and ideas to everyone including their competition. By making daily disclosures, the fund managers effectively telegraph the moves they make every day and potential “copy-cats” could just follow along without having to pay the management fees.

The second major concern is with regards to front-running. If a portfolio manager intends to build up a significant position in an illiquid security, he often has to do it over several trading days so as not to “move the market.” However, if, during their multi-day trading program, outsiders can see which positions are being added to or reduced, they could potentially front-run the pending trades of the portfolio manager.

Some attempts are now being made to address these concerns through the development of a non-transparent active ETF structure, which would not require daily disclosures while still enabling market makers to ensure that the ETF share price is kept close to the fund NAV. However, looking at how long it is taking the SEC to approve applications for even traditional, transparent active ETFs, adoption of this new structure might still be a fair distance off.

Hurdle #3: ETF Adoption In Retirement Plans

Most retirement and 401(k) plans continue to offer only mutual funds to investors, thereby creating a clear obstacle to ETFs in general, not just to active ETFs. Part of this has to do with inertia amongst investors, while another part is just logistics.

Investors are used to and understand mutual funds well. They are simple and easy-to-understand investment vehicles that many are comfortable with. Even though ETFs have now been around for a decade, they are still a relatively new investment vehicle in the eyes of many. Active ETFs specifically are even more novel, though one could argue that they are more like your traditional mutual fund than index ETFs would be.

In this regard, investor education remains paramount, as investors have to understand the benefits of the ETF structure over mutual funds before they can make a conscious choice. The other part of this obstacle is in fact operational. Many plan administrators are just not equipped to handle ETFs. For example, mutual funds settle on a T+1 basis, whereas ETFs, like stocks, settle on a T+3 basis. This basic difference in itself creates an operational challenge for plan administrators.

However, this is one hurdle where some progress is being made. In recent years, there have been several launches of “ETF-only” 401(k) plans that only utilize ETFs in implementing portfolio strategies. In fact, Schwab (NYSE:SCHW) just recently launched an ETF-only 401(k) plan to take advantage of the benefits that ETFs have to offer. Advisors themselves are moving away from a commission-based structure where they get paid trailer fees from the mutual funds that they sell.

Once this train gets moving, that’s when active ETFs will have a real chance of kick-starting widespread adoption, because whether in an ETF or a mutual fund, investors will still continue to look for actively-managed strategies.

Disclosure: No positions in above-mentioned names.

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