Active Funds and Other Changes in the ETF Industry
by Tom Lydon and Charles Rotblut, CFA
Tom Lydon is editor and publisher of the ETF Trends website. I spoke with Tom recently about developments in the exchange-traded funduniverse.
Charles Rotblut (CR): It seems that, in part, the future growth in actively managed exchange-traded funds will be dependent on how the SEC applies the so-called ’40 act. Can you provide a brief explanation of what this act is and how it applies to ETFs?
Tom Lydon (TL): The Investment Company Act of 1940 set standards by which investment companies should be regulated. The standards dictate how investment companies operate (promotion, reporting, requirements, pricing and allocation). The Dodd-Frank Act of 2010 overhauled the 1940 act to provide more consumer/investor protection and uniform standards for products.
However, the 1940 act does not specifically outline an ETF structure, which means that ETFs don’t actually fall under the U.S. Securities and Exchange Commission’s regulatory eye. As a result, a fund manager would have to register an ETF in a roundabout way.
Potential ETF providers would need to register as an investment company under the 1940 act, and then apply with the SEC to obtain “exemptive relief” from certain 1940 act provisions that cover open-end mutual funds. Once the exemptive relief is obtained, the fund provider is free to launch an ETF.
Applicants seeking to launch an actively managed ETF follow the same steps as any typical ETF sponsor. Specifically, they have to go through the following steps:
Apply for issuance of shares of an open-end management investment company for use of “creation units,” which are redeemable only in large quantities;
Execute transactions of shares in a secondary market at negotiable prices;
Permit an affiliate of the ETF to deposit into and receive from the ETF securities along with purchases and redemptions of the ETF creation units; and
Lastly, permit investment companies and unit investment trusts to acquire shares above the Section 12(d)(1) limits.
Delays in being granted exemptive relief have been a problem within the industry, but the Dodd-Frank act has only managed to exacerbate the problem. Now, the SEC has even started to hold grants on exemptive relief for actively managed ETFs that use derivatives or leverage. They are being more diligent, especially as it pertains to active management and derivatives. Also, the fact that there are 700 applications for exemptive relief in queue doesn’t help speed things up.
CR: PIMCO is laying the groundwork for new active ETFs, and T. Rowe Price appears to be taking some regulatory steps as well. What trends are you seeing in the active ETF space? Particularly, what could be introduced over the next six to 12 months?
TL: It is true that major players are actively looking into the active ETF space. While actively managed exchange-traded funds have been around for a few years now, investor interest has only recently begun to pick up, especially interest in active ETFs based on bonds and other fixed-income assets.
As with any other million-dollar idea, new entrants will be vying for a piece of the market. Notable providers like Guggenheim, Eaton Vance and BlackRock have their sights set on the active ETF market. PIMCO wants to create an ETF based on its popular Total Return Bond fund PTTRX and T. Rowe Price wants to jump into the ETF industry with an emphasis on income. All things considered, the number of active funds available may soon double.
Potential fund providers also like the idea of active bond ETFs, since the risk of front running (the practice of trading securities just before a large investor attempts to enter a buy or sell order) is lower with bond funds, which are more weighted toward securities than stock funds. Front-running risk is higher with stock funds because individual equity issues can be more volatile and can be greatly affected by market fundamentals, economics and specific issues pertaining to the company. Bond issues tend to be less volatile and move more in sync within each fixed-income asset class. There are always exceptions, but we see volatility more often in individual stocks than individual bond issues.
Fund companies are wary of transparency laws that require disclosures of holdings on a daily basis for ETFs, and bond-orientated ETFs help mitigate the problem.
Currently, PowerShares, PIMCO, Grail Advisors/Columbia Management and WisdomTree provide actively managed ETFs.
CR: Any thoughts on how the growth in actively managed ETFs is going to impact mutual fund investors?
TL: For now, actively managed ETFs amount to a droplet in the $1 trillion ETF industry, and only a couple of the offered active ETFs are closing in on $1 billion in assets. In comparison, mutual fund assets total a little over $13 trillion.
However, this niche area of the ETF universe is growing, and eventually, investors will begin to realize the advantages of ETFs or active ETFs over mutual funds. The main drawing point here is that ETFs, even active ETFs, offer similar if not better services than mutual fund products at a fraction of the price. While mutual funds have been the traditional go-to investment vehicle, ETFs are becoming more mainstream, and investors who are willing to learn about ETFs will likely begin voicing their desire to see more ETF products.
CR: How does an individual investor determine when it makes sense to switch to an ETF that follows a similar strategy to that followed by a mutual fund they already own?
TL: First and foremost, investors will have to go through some due diligence and acquaint themselves with how the ETF product works. Investors will have many options available to them, since fund providers have launched a plethora of products that cover almost every aspect of the market.
Look at the track record of ETFs and similar mutual fund products. ETFs have proven to provide similar, if not better, performance numbers compared to their mutual fund counterparts.
As mentioned before, ETF costs are lower than mutual funds, and it does not take long before an investor realizes that the small gap in expense ratios between ETFs and mutual funds may mean a huge difference when compounded over the years.
ETFs also offer many other advantages over mutual funds. Mutual funds require a minimum dollar amount to invest, while ETFs, like stocks, do not have such requirements to be purchased, beyond the listing price of a single share on an exchange. Investors are allowed to trade ETFs throughout the day, whereas mutual funds trade only at the end-of-day net asset value price. Fund providers include greater disclosure into their ETF products. In addition, liquidity in ETFs is not a concern, since it is related to the liquidity of the stocks in the underlying index.
CR: Some brokers, such as Fidelity and TD Ameritrade, are offering commission-free ETFs. Is this a trend that is going to grow, and how does it impact investors?
TL: Some brokers are starting to offer free trades for in-house brokerage accounts. Schwab has commission-free trades on their ETFs for their clients. Fidelity has an agreement with iShares offering their clients free trades on some of the most popular iShares ETFs, as well as on their own ETF. TD Ameritrade offers free trades on more than 100 ETFs. The brokerage firm uses the help of Morningstar’s research to select ETFs that cover a range of asset classes and providers. These commission-free ETF deals have helped attract greater inflows and helped popularize ETF products, making them household names.
Charles Schwab is the largest ETF custodian in the U.S., with 20% of all ETF assets held in Schwab brokerage accounts. Since Schwab pioneered the “mutual fund marketplace” and “no-transaction-fee mutual fund trading,” I wouldn’t be surprised to see that model replicated in the ETF space. The questions is, who covers the trading cost? Look for securities lending to gain popularity among ETF custodians as a way to generate more income for brokers and possibly bring no-commission ETF trading into the mainstream.
CR: Could you explain what securities lending is, since some of our members are unfamiliar with the practice?
TL: Securities lending is when brokerage firms lend securities owned by a client to another party. This enables the brokerage firm to create additional revenue streams from commissions on the transactions. This is a common practice within the brokerage community.
CR: Any guidance for determining when it is better to pay the commission versus using a commission-free ETF?
TL: If you are a buy-and-hold investor, commission-free trading does not seem all that appealing, since you would just buy once and sit on the investment. However, day traders may find the commission-free offer quite attractive, since fees tend to add up after consecutive buy and sell orders. Also, be sure you know what you are buying into, even if it is “free.” If an investor is dollar cost averaging small amounts on a periodic basis, mutual funds or no-commission ETF programs continue be the best option.
CR: Commodity ETFs have grown in popularity. Some are backed by physical assets, such as the SPDR Gold, while others use futures contracts. What do should investors consider when looking at either type?
TL: Physical ETFs are backed by the actual physical commodity and the bullions are held in vaults. Precious metals ETF holders would own an interest in a fractional amount of the physical commodity. The average individual investor may consider physical ETFs over holding the physical commodity because of costs associated with storage of the commodity. Potential investors should be aware that profits in bullion-based ETFs are taxed as “collector’s fees” when held in a taxable account, compared to capital gains, but consult your tax professional for advice.
Futures add a time component to the price. When tomorrow’s cost is higher than today’s, the commodity is in contango. The reverse is called backwardation, which is much more lucrative for commodities traders, since ETFs will be rolling front-month contracts (contracts whose expiration date is the closest to the current date) at a profit. Investors should note that some ETFs have blind front-month roll strategies—before a contract matures, the futures contract is sold and the next month’s contract is purchased—but most ETFs purchase futures for months in advance. None of these ETFs claim to deliver the spot price of the underlying commodity.
Potential investors should also be aware of commodities that are in contango, specifically how commodities in contango may diminish overall returns of an ETF as a result of rolling futures contracts.
Futures-based ETFs are usually reported on K-1 tax forms. The profits are taxed at 60% long-term and 40% short-term capital gains rate.
CR: What other trends are you seeing in the ETF industry?
TL: The 401(k) space is also experiencing a revolution in investment strategies, as more individuals are asking for ETFs and more plan providers are implementing ETFs into 401(k) plans. ShareBuilder/ING offers a 401(k) plan (since 2005) with select ETFs to choose from, as well as model portfolios. Schwab will launch an all-ETF 401(k) plan in 2012. TD Ameritrade announced this spring that they will offer ETFs to 401(k) plan participants.
While ETF-based 401(k)s are not a new concept—some investment firms have been offering these services for years—large and established names are only recently beginning to see the benefits of offering their own ETF-based 401(k) services.
CR: What guidance can you give an investor for building a diversified portfolio of ETFs?
TL: The number one thing to look at is the holdings. Every ETF is created based on a different index. Even funds tracking similar benchmark indexes may have different holdings, since providers have their own goals when optimizing ETF performance and setting their fund products apart from the rest.
Additionally, a lot of broad market equities-based ETFs may also heavily favor a specific sector or area within the markets or select companies may account for a majority of overall holdings. For instance, country-specific ETFs, especially in the emerging markets, tend to hold a heavier weighting in the financials or energy sectors, and the combined weighting of the top 10 companies may be over 50% of total holdings.
CR: What is your viewpoint of high-frequency traders in the ETF space? In particular, how much of an impact is it having on fund investors?
TL: High-frequency trading, or algorithmic trading, may be viewed as an advantageous trading style that capitalizes on arbitrage mechanisms and threatens the stability of normal market operations. However, some may view high-frequency trading practices as a legitimate trading strategy that helps increase liquidity in markets, reduce spreads and diminish volatility.
While evidence has suggested that high-frequency trading wasn’t at fault during the flash crash of May 6, 2010, regulators have nevertheless placed their scrutiny on the markets and ETFs. For instance, stock circuit breakers were put in place to regulate any extreme changes in the market—any stock or ETF price that experiences a 10% change will have trades halted for five minutes. More recently, circuit breakers were triggered for three major energy contracts after one hit its limit.
High-frequency trading flourished under equities and futures markets, and it is moving into the commodities futures market and the foreign exchange market. These areas are highly liquid, and there are arbitrage opportunities within contracts. With the proliferation of ETFs, trading in these niche markets that were once restricted to the trading pits has now become much easier for high-frequency traders.
Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.