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As ETFs Evolve, New Species Emerge

NEW YORK (TheStreet) -- ETFs have grown 25% a year since 2002 and many experts see this growth continuing in the future.1

In addition to taking over a larger share of the broad market, ETFs could also grow in terms of complexity and structure. As index-based trading becomes more popular, as in the ETF market, ETF sponsors and index providers will "push to develop new and interesting indexes," says Michael Mundt, a partner at the law firm Stradley Ronon Stevens & Young and a former assistant director at the SEC who worked on ETF issues.

Currently, ETFs track major indices, bonds, commodities, derivatives, industries or even specific market caps. As investors demand more ETFs, more differentiation will emerge in the baskets of securities that ETFs track.

One area that has the "greatest potential for growth" is in actively managed ETFs , according to Mundt.

Actively Managed ETFs

Unlike traditional ETFs, actively managed ETFs do not necessarily track an index, but instead the fund manager regularly trades the underlying securities to meet a specific investment objective. Actively managed ETFs take only 4% of the ETF market, and usually have higher expense ratios and active risk than passive ETFs.

The first actively managed ETF was launched in 2008, but growth in these ETFs did not take off until 2010, when net cash flow jumped to $1.59 billion from $110 million in 2009, according to a report by Morgan Stanley Smith Barney.2

Within the past year, more funds have filed for actively managed ETFs, such as State Street Global Advisors and BlackRock.

Growth in these actively managed ETFs could further help the ETF market "emerge as a major competitor to mutual funds," says Mundt. Unlike mutual funds, actively managed ETFs have full transparency, so the manager must disclose the ETFs holdings on a daily basis.

Dave Mazza, a strategist in State Street Global Advisors' SPDR ETF Strategy & Consulting Group, has seen "increased conversations about innovation in active management" with customers. Mazza also expects the actively managed ETF market to take off, saying it has just taken the market "some time to understand the structure and benefits of actively managed ETFs."

Although actively managed ETFs may represent another investment tool with new benefits, investors should be aware of the different structure, risks and costs associated with these ETFs.

"These funds might outperform traditional market indexes, but they also carry the risk of performing worse than the market if the manager doesn't succeed in picking good investments," wrote Michael Iachini managing director of ETF research at Charles Schwab.

Actively managed ETFs "require a greater deal of research for investors to understand the manager's approach and objectives," says Mazza. To keep the risk and costs in line with their investment preferences, investors should understand the product they are buying and its investment strategy.

Nontransparent, Actively Managed ETFs

Although some experts see full transparency as a key component of actively managed ETFs, others see transparency preventing further growth in assets and strategies of the active ETF market.

"Unless regulators approve a structure that doesn't require full disclosure of an ETF's portfolio every day, some active strategies are unlikely to be introduced in ETF form," according to Iachini.

Some managers may be worried about "free-riding", since others can copy the manager's investment strategy due to the daily release of ETF holdings. Last year, BlackRock offered one solution by filing for nontransparent, actively managed ETFs with the SEC.

Dave Abner, Head of Capital Markets at WidsomTree, called nontransparency a "move backwards for ETFs". Full transparency is a key component of ETFs and "WisdomTree has proven that transparent ETFs can work and bring value to our clients, which is our ultimate goal" says Abner. One of the major benefits of ETFs over mutual funds is this full transparency, which allows customers to know the exact holdings in their ETF positions every day.

Nontransparent ETFs may just introduce even more confusion into the ETF market. Mazza says nontransparent ETFs would just require a "heightened level of due diligence" from investors and "may introduce opportunities for greater discrepancy between net asset value and market price."

According to Mundt, a challenge for non-transparent active ETFs would be to publish enough information about the portfolio to allow market participants to accurately price the ETF intraday, but not so much information as to permit people to determine the portfolio holdings. If market participants aren't able to make efficient markets in the non-transparent ETFs, investors and traders may stay away from the product.

Currently, investors cannot create or redeem ETF shares, putting them at a great disadvantage when price deviations exist. However, investors could possibly see some changes allowing them to redeem or create shares in the future.

In the SEC filing, BlackRock did describe specific situations where any investor would be able to redeem shares of the nontransparent, actively managed ETFs for a certain time period.

Future Growth

Mundt believes ETFs could also increase their presence through distribution channels, such as retirement plans. Increasing distribution channels would help ETFs take over a larger share of the market and be more competitive with mutual funds.

Looking to the future, Mazza sees the "possibility of accelerated growth in the ETF market and potential to take over a greater share of assets." Actively managed ETFs will be a significant part of that growth as investors get more comfortable with the fund manager and understand the ETF positions.

"ETFs and mutual funds can coexist in the marketplace," Mazza said, and only time will tell how much ETFs can grow and take over more of the market.

-- Written by Caitlyn Grudzinski in New York

ETFs Investigated: Introduction | Arbitrage | Correlation

1. Morgan Stanley Smith Barney, "ETF Quarterly", May 31, 2012
2. Morgan Stanley Smith Barney, "ETF Quarterly", May 31, 2012

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