The possibility of an actively managed exchange-traded fund, or ETF, has been bandied about for two years now, and the
Securities and Exchange Commission
once again renewed interest in the idea at last week's annual meeting of the
Investment Company Institute
, the fund industry's trade group. At the meeting, the SEC indicated that this summer it would look into the possibility of allowing actively managed funds to trade on exchanges.
In a bid to attract assets and make a name for themselves as groundbreakers, fund sponsors have been pushing for actively managed ETFs. But, oddly, they have said little about what benefits, if any, an actively managed ETF would have for investors. The amount of assets in index-based ETFs has
grown rapidly in recent years.
The greatest benefit an actively managed ETF could offer over an index-based ETF would be the opportunity -- if managed by a particularly adept portfolio manager -- to beat the indices, while still offering all the benefits of an index-based ETF, namely, low fees and trading flexibility.
"We publicize very loudly that 80% of fund managers can't beat the
. But what about the other 20%? They
beat the S&P 500," says Nate Most, a consultant to
Barclays Global Investors
on its 61 iShare ETFs, which are each based on different indices. Most was also one of the creators of the first exchange-traded fund, the
Standard & Poor's Depository Receipts
, otherwise known as Spiders, which came onto the market in 1993.
Also, if a fund company introduced an ETF share class of an actively managed fund, it could conceivably convince investors who trade frequently in and out of the fund to trade the ETF instead, which would make the other share classes far more tax-efficient, says Donald Cassidy, a senior analyst with
The biggest drawback to an actively managed ETF, however, is the possibility of price disparities developing between the underlying value of the assets held by the ETF and the price at which the ETF trades. This possibility has been the major stumbling point that has kept actively managed ETFs from being introduced in the U.S.
This price disparity can occur because the ETF and its underlying holdings trade separately. The ETF trades on an exchange while the underlying stocks in the ETF are also trading, and these prices can vary. Such price disparities are particularly likely to happen if the ETF's last trade is well before the market's close, at which time the underlying stocks in the ETF might have moved the fund's net asset value, or NAV, away from its trading price.
These price discrepancies open up the possibility for traders to arbitrage either a premium or a discount. If the ETF begins trading at a discount, for example, an investor can take advantage of that discount by purchasing the ETF creation units at the lower price and them redeeming those units for the underlying securities at the higher price at which they are trading. If the ETF is trading at a premium, a trader can do the opposite by shorting the fund and then buying the shares at a lower price to cover that position.
With index-based ETFs, specialists have been able to minimize the possibility of arbitrage by releasing or redeeming shares as a way of controlling inventory and, therefore, prices. There is concern, however, that specialists won't be able to maintain that same kind of inventory and price control over actively managed ETFs, because the specialists may not know what the underlying stocks in a dynamically trading portfolio are, explains Jim Pacetti, president of
, an ETF consulting firm.
"Index-based ETFs have succeeded in trading within a couple of basis points of their NAV because the holdings in the indices are transparent," Pacetti says. Any time a price disparity becomes apparent in an index ETF, it immediately gets traded away, he says. But for an actively managed ETF in which the holdings might not always be revealed, or might be revealed at various times to different groups of investors, it will be a lot trickier to keep the trading price of an actively managed ETF in line with its actual NAV, Pacetti says.
With respect to fees, though, an actively managed ETF would likely charge much lower fees than regular equity funds. Index-based ETFs can cost as little as one-fifth the cost of an actively managed equity fund. Actively managed ETFs are likely to cost more than index-based ones but still be considerably less expensive than a regular actively managed mutual fund, says Elba Vasquez, a vice president with
, a mutual fund research company.
And like index ETFs, actively managed ETFs would also offer all of the benefits of stocks, from allowing investors to trade them throughout the day, to shorting them, buying them on margin and being able to place put or call options on them.
of Frankfurt has dealt with the issue of disclosure and arbitrage by allowing
, a unit of
, to introduce 11 actively managed ETFs last November. DWS reveals holdings in the funds to institutional shareholders every day with a two-day delay, and doesn't share the information with the general public until it's a month old. The Bourse also tries to control the arbitrage issue by preventing the ETFs from trading beyond a bid/ask spread.
But the SEC isn't likely to allow such a disparity in disclosure between institutional and retail investors because it wants to maintain a level playing field for both groups, Pacetti says. He also is not sure if investors will be satisfied by an attempt to solve the arbitrage issue simply by keeping the bid/ask spread within a pricing band, because index ETFs have not had much premium/discount disparity.
If the U.S. mutual fund industry and the SEC are able to resolve the issue of price disparities, though, fund executives expect that the various benefits of these products will attract substantial money. While it has taken index-based ETFs nine years to reach $66 billion in assets, Financial Research expects actively managed ETFs to attract $60 billion in their first year of operation and swell to as much as $500 billion within five years. And this is the principal reason why sponsors have been so interested in introducing an actively managed ETF, fund executives say.
But while the possibility of actively managed ETFs has been raised time and again, Lipper's Cassidy doesn't think they will become reality for some time to come because of how guarded fund managers are about revealing their holdings. Fund managers have long been wary of revealing stocks they are purchasing for fear that others will see what they're buying and push prices higher before they're finished buying. Conversely, if word got out that a portfolio manager was selling a particular stock, other traders could start selling in advance and push the price downward.
While the SEC is talking about paving the way for actively managed ETFs, the commission has continued to say it will not push for more frequent disclosure of holdings. These two concepts are at odds and could thwart actively managed ETFs for some time to come, Cassidy says.