In Search of an Actively Managed ETF: Does it Already Exist?

by: Richard Kang

News of the coming actively managed ETFs has grabbed most of the attention in this young and growing industry over the past several months. The AMEX gave some details of an underlying structure for such ETFs at a conference in New York in early March. Even prior to that there were some media reports on this issue including this from John Spence at CBS MarketWatch. I have posted my views several times on rules based “strategy” ETFs and how I believe that they’re not really actively managed, although there are some that have very strong arguments. But what I’m talking about in this post is an actual actively managed ETF. No index tracking. An active manager making stock selection decisions on the underlying portfolio just like for a mutual fund. I sound like a broken record but again, the innovation comes from Canada.

First some background. On Thursday, April 12th, I attended a luncheon seminar organized by The Toronto CFA Society (their derivatives committee, in fact) to a full room of I’ll guess around 120 people. The first speaker was Howard Atkinson, President of Horizon BetaPro ETFs. BetaPro has a long and a short exposure set of levered Canadian equity ETFs linked to the S&P/TSX 60, the dominant large cap equity index in Canada. The underlying advisor for these funds is the same as those for the ProShares line of ETFs in the US. Howard is best known for leading the BGI iShares (formerly iUnits) group in Canada before recently moving to BetaPro and is also the author of “The New Investment Frontier” which is already in its third version. To me, it’s THE book for anyone (Canadian or not) on ETFs. Of course, there’s a big home bias in this book, but it still gives the important basics such as the underlying structure of ETFs (as well as other forms such as HOLDRs), the history and some stats on current funds … although with the pace of product development this book was already obsolete with the ETF-specific data even upon going to print … a problem with all ETF publications including the annual Morningstar ETFs 100. For every book out there, you really have to have an associated website to keep things up to date.

To credit Morningstar, and despite concerns I have with regard to their analysis of ETFs, they do have a website with a section specifically covering ETFs. I didn’t say their ETF website was a good one or not. Frankly, I’m not a subscriber to their service so I can’t say whether their ETF-specific analysis is of any value or not … nor did I in my posting which I just referred to. If someone is a subscriber to their service and wants to comment on it here, please do. There are quite a few sites that have databases with a decent amount of ETF related information (they’re free but clearly not as robust as you’d find on a Bloomberg terminal).

Getting back to the presentation: Like much of his book, Howard’s presentation covered in broad terms the basic topics of history and underlying structure. More importantly, he discussed the confusion today about ETF liquidity as well as related discussion of “true value”. He also quickly went through some recent offerings and the different strategies that can be applied with ETFs.

The second speaker was Peter Haynes, Managing Director of Index Products/Portfolio Trading (Institutional Equities) at TD Newcrest also here in Toronto. I focus so much on the markets and beta related instruments outside of Canada that I hadn’t familiarized myself with the local ETF specialists and researchers on the sell side (thanks Howard for the names!). Peter is one of these few specialists and considering that he was one of the people working on the first ETF ever on the planet (TIPS in 1990 and HIPS in 1993 which eventually merged in late 1999 to become what is now the iShares S&P TSX 60 Index ETF), you could and should say that he’s pretty much been in the ETF business as long as anyone. Peter’s session focused more specifically on the Canadian ETF marketplace and the providers. He also had comments on the institutional use of ETFs and a behind-the-scenes look from the dealer’s side. In all cases, for everyone in the institutional space as well investment dealers with an ETF inventory … it’s all about risk management. No surprise there.

The big surprise, for me at least, was when Peter started to speak … in a rather “matter of fact” tone … about the first actively managed ETF. According to a slide from Peter’s presentation:

In early March [2007], conversion of FIE.UN from closed end fund [CEF] to ETF resulted in the first North American Actively Managed ETF. Street (other CEF providers) are watching FIE asset retention carefully.

I did some poking around and thanks to Andrew Leinwand of the Toronto Stock Exchange’s (TSX Group) Structured Products & ETFs Division we have this prospectus available on SEDAR for the Claymore Canadian Financial Monthly Income ETF (ticker FIE on the TSX).

By the way, “SEDAR” is the System for Electronic Document Analysis and Retrieval, a filing system to provide access to most public securities documents and information filed by public companies and investment funds with the Canadian Securities Administrators [CSA].

I couldn’t find a way to link to the pdf file directly through SEDAR so here’s how you go to download the prospectus.

1. Go here.

2. In the text entry box under “Investment Fund Name” enter [Canadian Financial Income] but of course without the brackets.

3. Under document type, choose [prospectus] then click [search].

You should get four matching results, the top one being the English language prospectus. The prospectus is actually for two ETFs. The second ETF listed is a fundamentally weighted fund with Research Affiliates as the underlying advisor. Claymore has anchored itself firmly in the fundamental camp in Canada with multiple offerings based on this indexing methodology from RA. But the purpose of this posting is to focus on the Claymore Financial Income Fund (abbreviated as FIE in the prospectus). The third paragraph found on the first page of this prospectus reads more like a description for a mutual fund than for an ETF with a clear objective related to active management. It reads:

FIE’s investment objectives are to maximize total return to its Unitholders, consisting of distributions and capital appreciation, and to provide its Unitholders with a stable stream of monthly cash distributions of $0.05 per FIE Unit. FIE’s net assets, together with borrowings under its loan facility, are invested in a diversified and actively managed investment portfolio consisting primarily of common shares, preferred shares, corporate bonds and income trust units of issuers in the Canadian financial sector (the “FIE Portfolio”). MFC Global Investment Management (Canada) acts as investment advisor to FIE.

I’ve emphasized the text with regard to the fund’s objectives. There’s no mention of tracking an index but rather maximizing total return. It also mentions the underlying investment advisor as MFC Global Investment Management, part of the global financial conglomerate Manulife Financial. If the part of this being an actively managed fund wasn’t clear, two paragraphs down is this passage we find this:

MFC Global Investment Management (Canada) (the “Investment Advisor” or “MFC Global Investment Management” or “MFC Global”), a division of Elliott & Page Limited, a Manulife Company, acts as the investment advisor to FIE and actively manages the FIE Portfolio on behalf of FIE. MFC Global, one of North America’s largest and most experienced asset managers, and its affiliates provide investment advisory and portfolio management services to institutional clients and investment funds and, as of September 30, 2006, had over $230 billion in assets under management.

Again, I put in bold text the key phrase. Also note that on page 5 within the “Prospectus Summary” section, under the “Investment Approach” subsection, the document gives greater detail on the degree and scope of active management applied within the fund.

But from the second quote above we again see quite clearly it states that the investment advisor “actively manages the FIE Portfolio on behalf of FIE” (as if the third party investment advisor would be hired to passively manage the fund?!), although it’s not very sexy in that the fund’s investment universe are securities in the Canadian financial sector. Funny, with all the talk of Bear Stearns’ SEC filing for an actively managed ETF, in this case it’s about active management within money markets. For those interested in doing some comparison shopping, here’s the link to the Bear Stearns prospectus. I found this link from Matt Hougan’s article on IndexUniverse (registration required but it’s free) with early news on the filing.

I would be wrong to not highlight the fact that this Claymore ETF has a 100bps management fee. That 100bps fee seems to fit the smell test … this guy’s actively managed. The fundamentally weighted ETF has a management fee of 65 bps and I don’t consider it nor other rules based strategy ETFs to be actively managed. By the way, here’s the chart which shows that it’s only had a few days of trading and despite it being an interesting development, clearly it’s not that interesting when you consider the trading volume:

ca fie

One more note: I just received the latest “ETF Worldwide Guidebook” from Deb Fuhr at Morgan Stanley along with the usual set of additional guidebooks. Page 44 of this guidebook has a listing of Canadian ETFs including the Claymore Canadian Financial Income ETF although it only lists the name of this fund not any additional detail such as ticker symbol or cost (NYSE:TER). But it does again confirm the fact that this actively managed fund is classified as an ETF.

The ETF industry seems to be taking baby steps into active management … and that’s a good thing. A lot of people (in Canada at least) are looking at these late events and are eager to be second to market. I’m eager to see the response from outside Canada once I post this story. Despite all the comments about the importance of being first to market in the ETF industry (think GLD versus IAU), there’s little point in being #1 and swinging for the fences when you have no clue what to expect.

But this makes me think of all the news in the US of actively managed ETFs and the dawn of a new age [Please note that when I talk of an “age” in the ETF timeline, we’re talking about a year, ok?] So, there was some news of an actively managed ETF out of Germany (some say it’s not) and now we have this CEF to ETF conversion that could potentially lead to other CEFs switching sides. Will we see a mass migration of this sort? More importantly: Why hasn’t this news in Canada made headlines elsewhere … actually, I don’t think it really made headlines here either. Why is that?

This would seem like the forgotten, or somewhat undiscovered passage for the move towards truly actively managed ETFs. Or maybe not. Perhaps, like Peter Haynes had said, there are many other participants in this market watching developments here in Canada as well as in the US. And if so, then there could be some very interesting further developments in the closed end fund/exchange traded fund world. As a review/primer for those unclear about the difference between CEFs and ETFs, I bring this excerpt from a recent article on the Morningstar website:

Most individual investors never deal directly with an ETF the way they would with a traditional mutual fund. Individuals and financial planners buy and sell ETFs among themselves via a broker. In this way, they are similar to closed-end funds. But the similarities end there. Closed-end fund shares can trade at large premiums or discounts to the net asset values of their underlying portfolios. ETF discounts and premiums tend to be much smaller, though, because ETFs can do something closed-end funds can’t: continuously create and redeem shares in-kind. This means that the ETFs exchange fund shares for baskets of their underlying securities and vice versa.

This in-kind creation/redemption process creates an arbitrage opportunity for large institutional investors and market makers, known as authorized participants, who deal directly with the ETF. This helps keep ETF premiums and discounts narrow. When ETF shares trade at a discount to the NAVs of their underlying holdings, the APs buy the ETF shares and sell the underlying securities. If the ETF shares trade at a premium, the APs buy the underlying securities and sell the ETF shares. In the process of taking advantage of these arbitrage opportunities, the APs drive ETF market prices and NAVs close together.

That was from Dan Culloton. In addition to this article being well written in my opinion, by linking to this Morningstar webpage, I also wanted to show that I’m not completely … almost, but not completely … anti-Morningstar. Let me be clear: I’m not so sure of the value of someone telling me “this” mutual fund is better than “that” when a strong majority of these funds are closet indexers. Not all, but a very good number of them. I’m even less sure of the value when applied to ETFs. Furthermore, the star system, to me at least, seems to be the absolute perfect example of the phenomenon of “chasing returns”. I wonder if anyone has ever run a mandate where long positions were established for funds with the top ranking and shorts were established for “no stars” (if there is such a thing as no stars)? I know, that would be stupid but I’d just be interested to see the results. Backtests are only shown for successful backtests. If there is none for this “strategy” (I use quotation marks for obvious reasons), then we probably know why. End of rant.

Back to CEF to ETF conversion story. I’m hoping that this posting leads to a lot of discussion and if so, I hope to follow up with some Q&A with various analysts in the ETF space. I’d like to get some reaction on this particular fund conversion process and their outlook on the future of actively managed ETFs both here and in the US.

In essence, the closed end fund story is quite simple. Just like any index can be traded on an exchange through an ETF, so can a mutual fund (so to speak because it’s actively managed and has a net asset value) be traded on an exchange as a CEF. The well publicized flaw of CEFs is the spread between the CEF’s market price and the underlying fund’s NAV thus if the conversion to ETFs appropriately deals with this, as it should, yet also makes economic sense for the fund provider, this could lead to a significant number of actively managed ETFs on the market. But there’s a big “IF” in there. With all the uncertainty of this, I’m thinking that if this was such a great idea, it would likely have already been done. I’m guessing it’s simply an issue of going through the regulation process and if so, that’s fine. What’s the rush, right? But then, this makes me think of a long list of additional “IFs”:

  • If a mass conversion of actively managed closed end funds to ETFs occurs, what are the ramifications to the other participants in the ETF industry, in particular the mutual fund industry, but also to the broker/dealer community, and heck just about everybody?
  • If developments lead to a robust and growing actively managed ETF industry, would this further confirm my feelings of a divergence in the ETF space: low cost broad market cap weighted index exposures at one end, and pretty much every else with a higher fee attached to it on the other end.
  • If this were to happen, then suddenly the new infrastructure and real estate ETFs (among many others) brought to market recently would have more direct competition from relevant CEFs that become converted. Same with many other asset classes and sub-categories. I wonder what the mutual fund executives think of this? Not another dagger. Certainly, many will have to adapt: Hey Morningstar, you’re back in business! I hear a sigh of relief from mutual fund analysts everywhere as active management truly makes it way to ETFs. Caveat: remember that it’s “IF” such developments occur. Just kidding … there’s really nothing for mutual fund (or active management) analysts to worry about. The financial services industry was built for active management and it’s just a matter of time before the ETF industry gets pulled in.
  • Last “If”: If John Bogle didn’t like the direction the ETF industry was taking in 2006, you have to wonder what he thinks about it now.

    Why am I picturing floodgates being opened?