From the June 2008 issue of Wealth Manager Web • Subscribe!

June 1, 2008

But Will They Come?

Here's a bit of sobering news for the ETF industry. For the first quarter of 2008, only 27 new funds were introduced. That's only a little over a quarter of the number of funds introduced in the first three months of 2007.

The rapid deceleration in ETF launches thus far in 2008 begs the question: Is the growth party over for new ETFs?

Certainly it would be unreasonable to expect the number of ETFs to grow at the feverish pace of 2006 and 2007, when some 400 funds were introduced into the marketplace. And it's no surprise that the slowdown is occurring during a bear market, when investors' appetite for virtually any investment vehicle is less voracious.

Still, to see the number of new ETFs decline 71 percent year- over-year has to make ETF sponsors--especially the smaller ones fighting for the crumbs left by industry giants Barclays and State Street, which together control more than 78 percent of all ETF assets--squirm a bit.

One problem, of course, is that the founding concept of ETFs as investment vehicles that mimic an underlying index has probably been taken as far as it can possibly go. There are now more than 640 ETFs based on underlying indices. There are ETFs that mirror traditional indices (S&P 500, Dow Jones Industrial Average, etc.). There are ETFs that mimic indices based on commodities, currencies, sectors and countries. There are ETFs that mimic indices weighted by market cap, dividends and other metrics. There are ETFs that promise double the return or double the inverse return of certain indices.

In short, virtually no stone has been left unturned when it comes to spinning new ETFs from indices. Yet, the lack of success by many index-based ETFs to raise assets has no doubt given pause to sponsors considering new index-based ETFs, as evident by the big drop in launches in the first quarter.

It's no surprise, then, that the industry is placing a lot of hope on what it sees as its next major growth driver-- "active" ETFs.

But are active ETFs going to be the vitamin B-12 shot that reinvigorates the ETF industry? Will the ETF sponsor mantra--"if we build it, they will come"--hold up when it comes to active ETFs?

To be sure, there's one number that would seem to indicate that active ETFs could spur big numbers of new ETFs. That number is 7,500--the number of traditional open-end mutual funds.

Rest assured that ETF sponsors look at that number as a benchmark for what the ETF industry could become. And the fact that the number of new open-end mutual funds in the first quarter (98) more than tripled the number of new ETFs is not lost on ETF sponsors.

Still, I'm not convinced that active ETFs will be the moon-shot that many ETF watchers expect. Here's why:

Transparency.

Transparency is an important word when it comes to ETFs. Full and complete and frequent disclosure of an ETF's holdings--transparency--is the guiding regulatory principal behind ETFs.

Transparency works well when you are talking about ETFs based on indices. It gets a little messy when you are talking about "active" ETFs.

Now I know ETF sponsors have already been working on a variety of schemes to deal with the transparency issue. And the fact that, at the time of this writing, five active ETFs have been launched speaks to the ingenuity of those sponsors in dealing with transparency.

But I view transparency as being more of a problem for the industry from the demand side of the equation, not the supply side. I have no doubt that ETF sponsors will continue to create active ETFs that meet the transparency standards set by the SEC. But the big question that ultimately will decide the success of active ETFs is the following:

Do investors and especially advisors really wanttransparent "active" ETFs?

Of course, ETF sponsors answer that question in the affirmative. Active ETFs should be desired by investors, they say, for many of the reasons that index-based ETFs have become popular: the ability to trade intraday, greater tax friendliness and low expenses. And with active ETFs, you can now capture all of these benefits in baskets of stocks and bonds managed by some of the smartest minds on Wall Street--active fund managers who heretofore have been shut out of packaging their strategies in an ETF structure because of the index requirement.

But here is where I think the industry argument for active ETFs has the potential to run off the rails. To me, active strategies are only created by sponsors and purchased by investors if there is a shared belief that the active strategy provides an edge. Otherwise, you would simply buy an index and match your benchmark.

Now, if I'm a manager who believes my strategy gives me an edge in the market, am I willing to reveal my edge every day to the masses, and do so at cut-rate fees?

Herein lies the paradox of active ETFs. Investors would no doubt love to buy active ETFs managed by the best and brightest managers. But are the best and brightest going to want to make their active strategies available in an ETF structure--where their holdings are disclosed on a daily basis--when they can maintain the secrecy of their edge, not to mention make a heckuva lot more money, managing traditional mutual funds or hedge funds? Does it not follow, then, that the universe of active ETFs will consist of second- and third-rate managers without that edge who are willing to work for cheap and likely to underperform their benchmarks?

I realize I'm being a little harsh here. Certainly there are quality active managers who will offer their services to the ETF industry. But the reality is that even in the mutual fund world, most active managers fail to beat their bogeys on a consistent basis. And these people are paid pretty well for their efforts. Now, if the talent pool for active ETF managers is even thinner than it is for open-end mutual funds (remember, the best mutual funds with the best active managers aren't likely to undercut their fees to offer active ETFs), then it's not a stretch to think that you'll see even more manager mediocrity.

And there are other potential problems beside performance that may dampen investor demand for active ETFs. One is the so-called tax efficiency of ETFs. Yes, most ETFs are tax-friendly relative to open-end mutual funds. But a major reason for their tax friendliness is that they are based on passive indices. It's almost a certainty that active ETFs will have greater turnover, which is likely to lead to reduced tax efficiency.

And it's a certainty that active ETFs will carry higher expenses than index-based ETFs, thereby diminishing the fee advantage that index-based ETFs currently enjoy over open-end mutual funds.

Finally, it's hard to see how active ETFs will avoid the sort of problems that occur with active mutual funds, such as the potential for style drift. This is a huge deal for advisors. One of the nice things about index-based ETFs is their style purity. That purity makes it relatively simple to establish and maintain a desired allocation across size and style boxes. With active ETFs, advisors will be vulnerable to the same sorts of style and size drift that make allocating client assets across open-end mutual funds a challenge.

That's not to say that all active ETFs will struggle for an audience. One area where wealth managers would no doubt welcome active ETFs is on the fixed-income side, especially at the very short end of the maturity spectrum. For example, it would be nice to have a vehicle, such as an ETF that represents a legitimate surrogate for a brokerage "sweep" account. Typically, advisors are beholden to the sweep accounts or money-market instruments offered by the brokers that custody client assets. And let's face it: These sweep accounts are a better deal for the brokerage firms than they are for clients. A money-market account housed in an ETF structure would represent a potentially attractive option for wealth managers trying to generate higher returns on clients' cash.

One reason active fixed-income ETFs make sense is their potential appeal on the fixed-income side; it's not surprising that the first actively managed ETF was a fixed-income vehicle. The Bear Stearns Current Yield Fund (YYY) focuses on short-term, fixed-income instruments. True, trading volume in this ETF has been almost nonexistent since its launch in late March. But that's probably more a function of the now infamous Bear Stearns name than it is a repudiation of the concept. I can't help but wonder what demand would be like if Vanguard, for example, had been the first to market with an active ETF focusing on short-term instruments.

The table above lists the five active ETFs that have been launched. Interestingly, PowerShares is also offering a "low duration" active bond ETF. It's also worth noting that the three PowerShares active equity ETFs seem to be created using the quant-based methodologies that characterize many of PowerShares' index-based ETF offerings. This isn't the sort of freewheeling active management that investors tend to associate with active open-end mutual funds.

Obviously, it is way too early to tell how these and future active ETFs will do with investors and wealth managers. My gut says that while index ETFs were an easy sell, active ETFs--especially on the equity side--will be more difficult. One reason is that expected performance is not a huge factor in the decision to purchase index ETFs. You buy the ETF to cover a style box or to plug a hole in a client's portfolio allocation, and you are willing to accept the index return. Expectations for active ETFs will be much different. To investors and advisors, "active" means "alpha," which means expected outperformance will carry much greater weight in the purchase decision. Yet, without the ability to show back-tested returns (something ETF sponsors are able to market with index-based ETFs), and with the first batch of active ETFs still potentially years away from developing meaningful track records, it's likely to be much slower going.

All of which means if ETF sponsors are looking to attract big assets to active ETFs right out of the gate, they are likely to be disappointed.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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