From the August 2009 issue of Research Magazine • Subscribe!

Will Active ETFs Dominate?

A number of ETF providers have indicated plans to offer funds with active strategies.

During the late 1980s, "The Future's So Bright I Gotta Were Shades" soared to become a hit pop song for its optimistic outlook. A similar tone has overtaken product developers who are banking on the bright future of actively managed ETFs. Will active ETFs overtake traditional mutual funds?

It's been 16 years since the first ETF, the SPDRs Trust (SPY), was introduced on U.S. stock exchanges. And from the start, few could have accurately predicted the success of ETFs. They began as obscure trading instruments resembling closed-end funds, but with lower expenses, greater tax efficiency and no significant premiums or discounts to net asset value. Institutional money managers were quick to appreciate the benefits of ETFs and, in time, the investing public then followed.

Today, the bulk of ETF money is invested in funds that follow traditional indexes. Of the 744 U.S.-listed ETFs, just 15 funds use full-blown active strategies attempting to beat the market. Some see active management as a source of future growth.

While ETF assets are rapidly growing, they're still tiny compared to mutual funds. According to the Investment Company Institute, there's currently $9.69 trillion invested in mutual funds whereas just $540 billion in ETFs. Mutual funds have been able to hold their dominant position mainly because of their stronghold in 401(k), 403(b) and 457 retirement plans.

Active ETF Origins

The very first actively managed ETF was nothing short of a flop. The Bear Stearns Currency Yield Fund (YYY) debuted in March 2008 and within months of being introduced the fund was liquidated. The stigma associated with financially troubled Bear Stearns, along with turmoil in the financial markets, was too much for YYY to overcome. It wasn't a good start.

Weeks after the first active ETF was born, InvescoPowerShares launched the PowerShares Active Alpha Multi-Cap Fund (PQZ) and PowerShares Active AlphaQ Fund (PQY). Over the past year, both funds have not kept up with their peer benchmarks. For the one-year period ending May 30th, PQZ fell 46.64 percent compared to a 32.39 percent decline in the Dow Jones U.S. Total Stock Market (TMW). PQY has declined by 32.43 percent while the Nasdaq-100 (QQQQ) declined 29.01 percent. And PowerShares says its Active Mega Cap Fund (PMA) has outperformed its benchmark, the Vanguard Mega Cap 300 (MGC), by about 6 percent since its inception in April 2008.

Product Development

A number of ETF providers have indicated plans to offer funds with active strategies. According to the SEC filings, Claymore Securities is planning three actively managed ETFs, one of which will be modeled after selections made by top economist Art Laffer. The other proposed funds are the Claymore/S&P Commodity Trends Strategy ETF and the Claymore Active National Municipal ETF. Claymore currently manages 45 ETFs with around $1.4 billion in assets.

The Claymore Laffer MacroEconomic Global Equity ETF will be launched as a fund of funds, investing in a mixture of various ETFs. The fund will select ETF investments using global economic factors and proprietary research.

Grail Advisors, a San Francisco-based money manager, has also been aggressively pursuing the active ETF marketplace. In May, the firm launched the Grail American Beacon Large Cap Value ETF (GVT). The fund holds 122 stocks, with Microsoft, Royal Dutch Shell and Chevron representing the top three holdings. Brandywine Global Investment Management, Hotchkis and Wiley Capital Management and Metropolitan West Capital Management share responsibilities in managing the fund. GVT's annual expense ratio is currently 0.79 percent.

As promising as GVT's future may seem, investors have been slow to jump onto the active ETF bandwagon. Even though ETFs now account for more than 20 percent of all U.S. equity trading volume, actively managed ETFs have struggled to get their fair share of volume. GVT "is a clone of the Grail Large Cap Value Mutual Fund (AAGPX), which has been managed for 10 years and has respectable long-term performance," states Gary Gastineau, principal at ETF Consultants. Despite that track record, on some days GVT has no trading volume at all.

Nonetheless, enthusiasm for active ETFs is clearly on the rise. In early June, Grail registered four more active ETFs with the SEC. "One of our goals from the outset was to bring traditional, active fund managers to the ETF marketplaces, says William M. Thomas, CEO of Grail Advisors. This second set of funds will be focused on large-cap growth stocks, financial and technology stocks. RiverPark Advisors is slated to be the funds' primary money manager.

Overcoming Barriers?

Two problems confronting active ETFs are low trading volume and portfolio transparency.

While the creation/redemption process is the same as with index ETFs, low trading volume creates large bid/ask spreads on the price of ETF shares. "This creates asymmetric trading where the market maker is willing to sell to shares but not willing to buy them," observes Gastineau. "You need two-sided markets, which is created by net asset value (NAV) based trading."

The ETF product structure has proven to be more tax-efficient compared to traditional mutual funds. Because shares are bought and sold on an exchange, the trading activity of one ETF shareholder does not negatively impact the tax consequences of another. That said, an active ETF will buy and sell holdings more frequently compared to index ETFs, which will likely create higher internal brokerage costs and higher distributions of capital losses and gains.

The issue of portfolio transparency could be a major disadvantage for active ETFs. Mutual fund managers typically disclose fund holdings every few months. On the other hand, active ETFs disclose holdings daily or weekly. For funds with assets about $1 billion, this has the potential to create front running by market participants looking to make a quick buck at the expense of ETF shareholders. Recognizing this threat, Grail Advisors has three fund managers overseeing GVT in order to disguise which manager is making trades.

If you truly trust an active manager's record, having the ability to buy and sell ETF shares on a daily basis doesn't seem like much of advantage. This is especially true if daily portfolio disclosures put ETF shareholders at a disadvantage or handicap the fund manager's investment decisions.

The future prospects of actively managed ETFs seem both bright and at the same time guarded. "I think their prospects for success will largely depend on their being able to produce a favorable track record," says Tom Graves, equity analyst at Standard & Poor's. He adds: "The transparency issue could limit the willingness of high-profile fund managers to disclose their daily holdings. With mutual funds, holdings are typically 'discloses every three or six months."

Actively Managed ETFs: Fund Name/Ticker/Expense Ratio

  • Grail American Beacon Large Cap Value ETF/GVT/0.79%
  • PowerShares Active Alpha Multi-Cap Fund/PQZ/0.75%
  • PowerShares Active AlphaQ Fund/PQY/0.75%
  • PowerShares Low Duration Fund/PLK/0.29%
  • PowerShares Active Mega-Cap Fund/PMA/0.75%
  • PowerShares Active US Real Estate Fund/PSR/0.80%
  • WisdomTree Dreyfus Brazilian Real Fund/BZF/0.45%
  • WisdomTree Dreyfus Chinese Yuan Fund/CYB/0.45%
  • WisdomTree Dreyfus Emerging Currency Fund/CEW/0.55%
  • WisdomTree Dreyfus Euro Fund/EU/0.35%
  • WisdomTree Dreyfus Indian Rupee Fund/ICN/0.45%
  • WisdomTree Dreyfus Japanese Yen Fund/JYF/0.35%
  • WisdomTree Dreyfus New Zealand Fund/BNZ/0.45%
  • WisdomTree Dreyfus South African Rand Fund/SZR/0.45%
  • WisdomTree Dreyfus US Current Income Fund/USY/0.25%
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