PowerShares Capital Management has won the race to file the first-ever prospectus for an actively managed equity-based exchange-traded fund [ETF].
AER Advisors, an affiliate of the New Hampshire-based stock-research company Alpha Equity Research, will manage the funds.
The initial filing covers three equity funds and one fixed-income fund:
- PowerShares Active AlphaQ Fund: Fifty Nasdaq stocks chosen using a quantitative screening mechanism.
- PowerShares Active Alpha Multi-Cap Fund: Fifty U.S. large-cap stocks chosen using a quantitative screening mechanism.
- PowerShares Active Mega-Cap Portfolio: Fifty "mega-cap" U.S. stocks chosen using a truly active screening methodology.
- PowerShares Active Low-Duration Portfolio: A bond fund that aims to outperform the Lehman Brothers 1-3 Year US Treasury Index.
There is no word yet on listing venues, ticker symbols or expense ratios.
The Race For An Active ETF
Providers have been trying to launch actively managed ETFs for more than six years now, but have encountered a variety of stumbling blocks. The biggest issue has been figuring out how to disclose the contents of the portfolio without allowing others to "front-run" trades that the manager is making.
Transparency is important for ETFs primarily because of the way new ETF shares are created. To "create" shares in an ETF, a large institution typically delivers the individual stocks in the underlying index to the ETF provider: For the SPDR (NYSEARCA:SPY) ETF, for example, an institutional investor must deliver all 500 stocks in the S&P 500 in exchange for shares of the ETF.
(The process is reversed when shares are redeemed in large quantities.)
But if the active managers don't want to disclose their portfolios, how do the institutions know what shares to deliver during the creation process?
Everyone from the American Stock Exchange to ETF Consultants to Firsthand Funds has been working on this problem, and each has arrived at a different solution. But PowerShares is the first to have a formal prospectus filed with the SEC, and the first to pull the covers back on how that mechanism will work.
The PowerShares/AER Mechanism... And What Makes These Active ETFs
In one sense, these funds represent only a partial step towards active management. That's particularly true of the first two funds, the PowerShares AlphaQ Fund and PowerShares Active Alpha Multi-Cap Fund. Those are quant-driven equity funds, similar to the PowerShares Intellidex, First Trust AlphaDex and SPA MarketGrader ETFS. The funds rely on AER's "NOW" ranking system, which ranks using a variety of quantitative measures, such as stock and sector buying pressure, earnings growth, etc. Holdings are equally weighted.
What makes these "active" funds - and different from what's come before them - are two things:
First, the manager doesn't formally hew to any particular index. All other ETFs on the market today have an underlying benchmark index, which the manager tracks, and which must be calculated separately from the fund. The SEC has historically required it. These funds don't appear to have that benchmark index.
Second, and more importantly, investors will not always know what these funds are holding.
Each morning, PowerShares will disclose the contents of the portfolios on their web site. And most days, the fund manager will not be able to make changes to that portfolio. But on the last business day of each week, the fund manager will be allowed to make up to three trades.
These trade won't be reflected in the daily fund disclosure until the following Monday, meaning that, at times on, the fund portfolio will be different from the publicly disclosed holdings. This should give the manager room to trade without encountering the front-running problem. And, because it only occurs once a week with a limited number of trades, the fund value shouldn't too deviate widely from the published holdings.
Obviously, creations and redemptions can't reflect the fund holdings exactly. To get around this, creations and redemptions will be made with a basket of securities that will be similar too-but not identical to-the actual portfolio. In addition, there will be a small cash component to true-up the value of the creation/redemption basket with the value of the portfolio holdings.
In contrast to the other two equity funds, the PowerShares Active Mega-Cap Portfolio comes closer to being a true active fund. Rather than following a fixed quantitative screen, the prospectus gives the manager wide discretion to implement a portfolio.
Here's the description:
The Fund seeks to outperform its benchmark index by quantitatively evaluating fundamental and technical factors to forecast individual security returns and will apply proprietary and non-proprietary risk and transaction cost models to forecast individual security risk and transaction costs. The Fund's portfolio managers incorporate these individual security forecasts, using a proprietary program, in seeking to construct the optimal portfolio holdings and further manage risks.
The portfolio managers focus on securities they believe have favorable prospects for above average growth while keeping a low deviation between the return of the [ ] Index and the return of the Fund's portfolio. The portfolio managers will attempt to overweight securities with positive characteristics identified in the evaluation process and underweight securities with negative characteristics. The security and portfolio evaluation process is repeated periodically.
The portfolio managers will consider selling or reducing a security position (i) if the forecasted return of a security becomes less attractive relative to industry peers, or (ii) if a particular security's risk profile changes.
There is a quantitative backbone, but words like "attempt to overweight" make this seem more like an active fund than just another black box quant strategy. Moreover, the fund will also hold cash and can increase that cash position significantly if it wants to take a defensive position, and can use derivatives. That's a pretty broad leash.
Most importantly, the fund will be able to trade at any time and on any day, in contrast to the once-per-week trading of the other two funds. It can also theoretically trade as much as it wants. Changes in the portfolio will be reflected in the fund's published holdings on the following day, meaning the disclosed holdings may always be one day stale. In comparison, existing ETFs reveal their holdings daily.
This fund will follow the same creation/redemption mechanisms as the funds covered earlier, with representative baskets and a true-up cash component.
The fixed-income fund has a similarly broad mandate.
Will They Succeed?
The two-tiered nature of this prospectus is interesting. It's possible that the SEC may move forward faster on the pseudo-quant funds and move more slowly on the true-active portfolios, as those seem to be a major step further than the quant funds.
A bigger question than that, however, is whether these funds will be successful even once they launch. Even assuming that the system works perfectly and the funds trade near NAV without allowing front-running, will investors want to buy active ETFs?
On the upside, all the advantages that accrue to passively managed ETFs-improved tax efficiency, lower costs, etc.-will be even more advantageous in an active setting. Most actively managed funds are woefully tax-inefficient, and the creation/redemption mechanism for these ETFs should allow them to improve upon the tax efficiency of the funds.
But still, as active funds, these funds can't really promote backtested results, and have no performance track record to fall back on. Who will be the buyers of these funds in the early years? Of course, if they do well their first few years on the market, the money inflows will come. But these new funds are unlikely to be instant successes. (Even fans of active management may be concerned that two of the funds handcuff the managers to once-a-week trading.)
Still, after much waiting, it looks as if the era of actively managed equity ETFs is truly set to begin. It should be interesting...
Written by Matthew Hougan
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