Proponents of actively managed exchange-traded funds (, like Chicago Cubs fans, have been saying “just wait until next year” for quite some time. For both groups, the mantra has become a scratched record from playing it over and over. It may continue to be so for North Siders, as the Cubs’ current rebuilding phase is ongoing. Active ETF proponents, however, may finally get the good news they’ve been waiting for.
The Securities and Exchange Commission (SEC) is mulling over various proposals for structuring active ETFs. A ruling could come before the end of the year. The scuttlebutt suggests the SEC will give the ETF industry an avenue to facilitate more actively managed ETFs.
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“Wait, aren’t there already actively managed ETFs?” you might ask.
Yes, and I’m glad you asked. There are currently 97 actively managed ETFs in the United States. The three largest are PIMCO Enhanced Short Maturity (MINT), PIMCO Total Return (BOND) and AdvisorShares Peritus High Yield (HYLD). Cumulatively, these three funds have assets under management (AUM) of $8.3 billion ($3.8 billion, $3.4 billion and $1.1 billion, respectively), as of June 30, 2014. The combined AUM for all of the other 94 actively managed ETFs is $8.8 billion.
With a few notable exceptions, actively managed ETFs have not attracted much in the way of investor dollars. In fact, more than 70% of actively managed ETFs have less than $100 million in AUM. Some of this may be due to the young age of these types of funds; about a third were launched within the past 12 months. A bigger reason may be the lack of participation by large would-be players. Many fund companies don’t want to launch actively managed ETFs because of the transparency requirements.
Exchange-traded funds are required to disclose their holdings on a daily basis. This facilitates the exchange of creation units. Creation units are blocks of 50,000 or 100,000 shares of ETFs. Authorized participants, such as market makers, can either exchange creation units or a basket of securities comprising the creation units with an ETF’s sponsor. The regular exchanging of creation units helps to keep ETFs efficiently priced.
Transparency works well when an index is used. Actively managed funds do not follow an index, relying instead on the fund manager’s ability to handpick securities. If full transparency is mandated, fund families worry that traders will jump ahead of whatever change the ETF manager is trying to make. An example of this would be a stock that a fund manager is trying to buy shares of. The ETF manager may want to buy the shares over several days to reduce transaction costs, but traders could jump in ahead and drive up prices, thereby increasing the fund’s costs. The net effect would be compromised performance for the ETF.
To get around the “front-running” problem, some companies have asked the SEC for exemptive relief. These requests involve altering the transparency rules. Eaton Vance subsidiary Navigate Fund Solutions, whose representatives I met with at the Morningstar Investment Conference in June, wants to both have the fund’s net asset value determined after the market closes each day (like a mutual fund) and to refrain from disclosing changes in the fund’s portfolio until the trades have been completed. An SEI report says BlackRock wants to launch ETFs with portfolios held in a blind trust, while Vanguard and Guggenheim want to use proxy portfolios to get around the transparency rules. The Eaton Vance and BlackRock proposals would allow for the transfer of cash to facilitate the exchange of creation units to limit the possibility of a fund trading at a notable premium or discount to its net asset value.
If the SEC does approve one or more of these “hybrid” ETFs, I would suggest taking a wait-and-see approach before buying them. There simply isn’t enough incentive to be a first mover when a new type of investment product is launched. Let the products attract dollars and allow time for whatever quirks may appear to be worked out. These new ETFs may well turn out to be good products, but it doesn’t hurt to tread carefully.
Wishing you prosperity,
Charles Rotblut, CFA
Editor, AAII Journal