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ETFs Get Active

Katie Benner

Mutual funds may not have the low management fees, easy-to-use structure and perceived transparency of exchange-traded funds, but they are typically closely monitored by money managers who reallocate their portfolios to give investors the very best returns.

Now ETFs want in on this game, too. ETFs are designed to merely track indices, but new products are appearing that give investors the benefits of active management. Moreover, some industry watchers say that true actively managed ETFs aren't far off in the distance.

"If you look at the more recent crop of ETFs, you'll see funds that are based on indices that are intended to be 'better indices,'" says Tony Baker, managing director of the exchange-traded marketplace at the American Stock Exchange. "They are based on someone's research that indicates that this basket of stocks [has been carefully chosen] to be better than a standard index."

These new forms come as the traditional marketplace for ETFs becomes more and more crowded with products focusing on very narrow segments.

"There are not many more ways to slice and dice [indices]. We're in the ninth inning there. But in terms of the next generation of ETFs, we're in the first inning," says Dan Waldron, vice president of ETF product development for First Trust Portfolios.

His company's First Trust Strategic Value Index Fund(FDV Quote) tracks 40 stocks selected from the S&P 500 based on price-to-earnings ratios to create a basket of value stocks. The portfolio is then reconstituted monthly using these criteria, making it very close to an actively managed portfolio.

"Alpha is the buzzword you're going to hear, and in the next generation of ETFs, it's all about generating alpha, or above-market returns," Waldron says. "As needs have evolved, clients are demanding performance above, say, the S&P 500... You are seeing in these ETFs things that fund managers already do, which is screen stocks and look for certain investment attributes."

Waldron says that First Trust wants to capitalize on active management strategies to generate even better returns. The company is working with index providers that create strategy-based indices.

The company has eight ETFs on the market and expects to have 15 or more ETFs by the end of the year. "Anything going forward will be a next-generation ETF," Waldron says.

Other ETFs that use fundamentals to pick stocks include the family of funds from WisdomTree Investments that weight indices based on total cash dividends companies pay or their dividend yield. WisdomTree launched its first set of ETFs in June; last week the company filed to launch 10 more funds based on international sectors.

ETF giant PowerShares has a set of ETFs that are based on "intelligent indexes" that use 10 factors to determine whether a company fits into an index at any one time: projected and actual earnings, sales growth, cash-flow growth, book growth, P/E ratio, price-to-sales, price-to-cash flow, price-to-book and dividend yield. Stocks are then chosen based on fundamentals, valuations, timeliness and risk.

Management on the Horizon

Waldron believes that investors will take a wait-and-see approach to the new nearly managed indices to see if they do indeed generate alpha. In the meantime, Baker says there providers working to come up with an actively managed ETF that suits both investors and portfolio managers.

But disclosure issues have held up the process. The Securities & Exchange Commission requires an ETF to publish the net asset value of its holdings every 15 seconds so that the market can accurately track the NAV with relative accuracy throughout the trading day.

"The problem with an actively managed ETF is a concern that if you publish the NAV every 15 seconds, when the manager is changing a portfolio, smart people out there will be able to look at the NAV and see how it is changing and be able to reverse engineer what the manager is doing," says George Simon, an attorney with law firm Foley & Lardner. Simon represents firms in the securities industry and was formerly the associate director of the SEC's Market Regulation division.

And if it's possible to figure out what the fund manager bought or sold, it would then be possible to front-run the fund, which would put the ETF at a disadvantage.

"There's a tension between what fund managers want to do, which is to at least keep what they're doing quiet until they finish doing it, and [the] SEC's desire for complete transparency," says Simon.

The Amex's Baker says that the ETF issuers are balking at managed funds because of the disclosure issues, and that regulators are "perfectly willing to consider" them.

However, he said that in the not-too-distant future, we'll see managed portfolios that disclose holdings in a generic sense using a proxy, or tracking, portfolio.

This tracking portfolio will mimic the intraday movement of the fund itself, but can't be used to reverse engineer the holdings of the fund, says Baker.

"The proxy portfolio may or may not contain the names that are in the actual [actively managed ETF]... It will be made up of securities that are weighted to mimic the performance of the ETF," he says.

This proxy portfolio exists to give the market makers and specialists enough information to fairly price the ETF. Baker says that ETFs such as these will be in the pipeline soon and likely will appear on a case-by-case basis.

Higher Fees

With active management, it's likely that the low underlying fees that have made ETFs so attractive will go up, but ETFs will still retain a tax advantage relative to mutual funds.

When a fund manager sells a large position, there could be millions of dollars in capital gains. Investors have to pay taxes on those gains.

But Simon notes that because of the way ETFs are structured, they will not be subject to the same tax liabilities if the holdings within an ETF change.

"The advantage tax-wise should offset some of the higher fees that will probably be charged," says Simon.