From the October 2011 issue of Research Magazine • Subscribe!

The New Wave of Active ETFs

A surge of new actively managed exchange-traded funds is gaining advisor interest amid a volatile market

That new kid on the block with the monogram “ETF” isn’t just passing through town — the exchange-traded fund is here to stay. And what’s been hyped for three years as the next big thing in the hot ETF market, actively managed ETFs, may soon spark major change, when Pimco launches an ETF version of its Total Return mutual fund — the world’s largest taxable bond fund. Last April Pimco, which already trades four active ETFs, filed required papers with the SEC to offer a Total Return ETF.

Alongside the immensely popular passive ETFs that track indexes, there are currently trading at least 36 active ETFs, whose managers seek to outperform the indexes. Apart from a handful, though, these aren’t offered by large providers with wide-ranging distribution networks and have generally failed to attract a high level of assets.

The Pimco Total Return ETF is expected to be managed — as is the more-than-20-year-old Total Return mutual fund — by famed Bill Gross, a Pimco founder and co-chief investment officer.

In addition, more mutual fund providers are forecast to follow Pimco in introducing actively managed ETF versions.

“Pimco Total Return will be the real test of the actively managed ETF market. All good things about passive ETFs — liquidity, transparency, tax efficiency, low cost — are even greater with an active manager in the ETF vehicle,” says Scott Burns, director of ETF research at Morningstar, in Chicago.

Created for institutional use in 1993 and mainstreaming into retail since about 2003, ETFs are now an established investment vehicle, primarily used for equities.

“The [modern] mutual fund was cutting-edge when it was created in [1924]. In contrast, the ETF is a digital technology” for today, Burns says.

Still, plenty of financial advisors have not adopted them. “The most common reason is that ETFS are passive products, and they value active management,” says Alec Papazian, senior analyst at Cerulli Associates, a Boston-based research firm specializing in the financial services industry. “With Pimco’s track record and credibility, the Total Return ETF could be a game-changer for the active ETF industry.”

It could also be a boon to the entire ETF space — not that it isn’t flying high. For the first half of 2011, flows into the United States ETF market were 36 percent higher than in the year-before period, according to BlackRock, issuers of iShares ETFs. As of August 9, 2011, assets under management in U.S.-listed ETFS came to a whopping $994,085,426,608, Morningstar says. BlackRock predicts that the second trillion will be reached by the end of 2014.

Of the 1,039 ETFS now trading, BlackRock notes, 143 were launched this year. As of August 2009, there were just 768 U.S. ETFs, according to Morningstar.

ETFs’ robust growth has been fueled by three drivers: a push by investors into low-cost vehicles, which increasingly has meant passive investing versus traditional active management; a move by investors who formerly bought single stocks or bonds into macro-theme ETFs; and institutions seeking passive exposure by using ETFs instead of over-the-counter swaps and other products they traditionally employed. Burns calls this “an echo resurgence” in institutional use.

And, on the near horizon, a new wrinkle: actively managed ETFs within non-transparent portfolios that trade relative to closing net asset value. Unlike mutual funds, all ETFs now trading must disclose their holdings daily.

“Within a year or so, you’ll see a significant number of funds, from household names that currently offer actively managed funds, with non-transparent portfolios similar to actively managed mutual funds,” says Gary Gastineau, principal of ETF Consultants, in Summit, N.J, who formerly directed product development at the American Stock Exchange.

Though they are yet to develop active ETFs, says Papazian, a number of firms, including Alliance Bernstein, BlackRock and JP Morgan, have already filed with the SEC for exemptive relief from certain rules of the Investment Company Act of 1940 — a process required to launch an ETF.

“These firms are thinking: Let’s file now — and in a year-and-a-half, if we decide to develop active ETFs, we’ll have that out of the way,” Papazian says.

But, despite BlackRock’s filing, Jennifer Grancio, head of BlackRock’s iShares U.S. distribution, is not anticipating “huge assets to be raised in the active ETF space by the first generation of active funds. We think it’s going to be about three years before we know what the market will look like on the active side. We hear limited interest from our clients, who say they aren’t unhappy with the traditional active alpha-generating individual funds.”

In a perfect world, passive and active ETFs will coexist. “There’s room for both,” says Charles Sizemore of Sizemore Capital Management, in Dallas, and editor of The Sizemore Investment Letter. “If you find a good manager, an active ETF can definitely add a couple of points to your return every year. But there will be times when passive index exposure — in bonds or stocks — is exactly what you want.”

Active ETFs that offer a twist are expected to do well, according to J. Garrett Stevens, founder-CEO of Exchange Traded Concepts, who is helping RIAs to private-label their own ETFs (see sidebar “Private Label”).

“If you have, say, a different kind of large-cap growth strategy — maybe a sector rotation or a currency strategy — that’s more opportunistic, there’s a place for that,” he says.

Among those who are failing to get excited about active ETFs, James Peters, CEO of Tactical Allocation Group, managing more than $1.5 billion in three ETF-based portfolios, says: “I don’t see where they add any compelling value other than being cheaper in cost and having a tax advantage over the traditional mutual fund.”

Moreover: “We don’t want to do an actively managed ETF because we don’t want our holdings displayed at the end of every day and let competitors see what we own — and then have them arbitrage it one way or another. That might make the ETF a little less effective than the mutual fund,” says Peters, based in Birmingham, Michigan.

Many believe that ETFs — which, like individual stocks, can be traded all day — are contributing to the market’s wild volatility, especially in commodities.

“Today, the market moves so quickly, and ETFs have added to that volatility. They’re so widely used, especially by the hedge fund industry with huge positions traded that you really have to watch out,” says Craig Pastolove, senior vice president and family wealth director of Excelsior Wealth Management at Morgan Stanley Smith Barney, in New York City. Of the team’s $500 million under management, $200 million is in ETFs. In addition to using them for individual portfolios, Pastolove works the funds for institutional clients in 40l(k) defined benefit plans.

At the same time that they are likely exacerbating volatility, exchange-traded funds are being employed as a hedge against it.

“ETFs serve as a ballast for these trying times. Retail advisors using them that way is pretty new, but institutions have done so for a long time,” Burns says. “Advisors are looking to diversify portfolios away from that volatility and get returns better than, say, Treasuries.”

To be sure, ETFs allow FAs to be more nimble in the face of buffeting market swings.

When the Dow plummeted 600 points one day last August, ETF investors “could have gotten out first thing that morning when we were down 150,” notes Stevens. “That’s one of the biggest advantages of ETFs — being able to react faster.”

Pastolove says that when he formerly allocated assets only to money managers, before moving heavily into ETFs, “it took a few days for the managers to even look at the money, let alone invest it.” But in last summer’s gyrating market, “we were able to buy immediately and take advantage of what we thought was opportunity.”

But as efficient as ETFs are, if invested with imprudence or using inappropriate funds, the vehicle can backfire.

“An ETF is like a gun — in the right hands, it can be used effectively and efficiently. In the wrong hands, it can be deadly and lead to financial destruction,” Sizemore says. ETFs’ famed liquidity is double-edged. “The flip side to being able to get in and out of the market quickly is the tendency to overtrade, and that’s one of the biggest detriments to long-term investing success. Financial advisors get lured into it, and they do so at their own risk.”

Emerging Niches

Two types of ETFs that have won only a small fan base — and correctly so, it seems — are the leveraged ETF and the inverse ETF.

Both “have really had some problems,” Stevens says. “They were either improperly sold or marketed or not fully understood by advisors. There’s been some damage done to the reputation of these products, and it’s going to take a while to work out.”

Designed to increase returns using borrowed money, leveraged ETFs are “risky and not right for long-term holdings,” says Papazian. “They’re meant to be held only for short periods. A lot of broker-dealer platforms say these products aren’t suitable.”

Sizemore considers leveraged ETFs “more of a gambling tool that encourage Mom and Pop investors to take risks they can’t afford.”

The inverse ETF, created to move in the opposite direction of an index, can be tricky to use. But Pastolove says he employs the inverse of the S&P 500 index “when we think it’s prudent to put a hedge on our portfolio without selling securities.”

Mostly, there’s plenty to cheer about in the ETF space; for example, the availability of emerging markets’ sector funds.

“They enable you to invest in emerging markets and also cherry-pick the sector you want to get into. So, for example, you can get direct exposure to emerging markets’ consumers,” says Sizemore. “Emerging Global Shares has a suite of ETFs that includes an emerging markets’ consumer staples ETF.”

And lately, individual country ETFs for both retail and institutional investing have risen in popularity. BlackRock’s Grancio, based in San Francisco, cites, in particular, Japan, Brazil, Canada and Germany. “Merrill Lynch advisors,” she says, “follow the firm’s country allocation model.”

In addition, Morningstar’s Burns points to “a lot of growth in the alternative space, like margin arbitrage and managed futures making it into the ETF wrapper — and with pretty good success for people looking for diversification. There’s a liquidity shift from the hedge fund wrapper into an ETF or mutual fund.”

But another controversial trend is the use of fundamentally weighted ETFs versus that of traditional market-cap weightings. Fundamentally driven funds provide an active tilt away from an index.

Stevens applauds them. “They give you different weightings for the portfolio without getting away from the indexing approach,” he says.

Peterson — keen on pure exposure to indexes — gives these funds a thumbs-down. “If we were to determine it makes sense to be in a large–cap growth index, that decision carries almost all the weight. We don’t want the variable of somebody exerting some form of judgment and active management that could either add or subtract value. We want the impact to be 100 percent our asset allocation.”

Though providers continue to bring out an endless parade of new ETFs, some may be suitable only for short-term trades: that is, if narrowly focused, they might be thinly traded and have little chance of longevity.

Sizemore once invested in a luxury goods ETF but, never attracting enough assets, the fund closed.  In 2009, Stevens launched a family of faith-based ETFs — for the five largest Christian denominations in the U.S. — but FaithShares is now defunct too. “Not enough assets were gathered to make it profitable,” he says.

The mini-trend to commission-free ETFs by discounters is expected to continue, a competitive strategy aimed at firm differentiation.  But Papazian notes that its “success has been mediocre as far as attracting assets goes.”

Over the next couple of years, ETFs for both retail and institutional investing are forecast to continue growing at a fast clip: 18 percent annually, according to BlackRock’s Grancio.

“Intelligent advisors should wake up to the fact that ETFs are here to stay and open their minds that they can be part of their business,” Pastolove stresses. “But they shouldn’t blindly start owning them: there are pitfalls — like certain ones are more expensive, some aren’t very tax efficient, and there [can be] inefficiencies in fixed-income funds.”

Nevertheless, the FA continues, “clients are seeing and hearing about exchange-traded funds; and to just tell people they’re not right for them is an easy way to lose business.”

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Private Label

It would be more than an ego trip to package an ETF under your own name and brand: offering a publicly traded product gives you credibility and can open a whole new distribution channel.      

Companies such as AdvisorShares develop funds for “sub-advisors.” But now comes Exchange Traded Concepts, based in Oklahoma City, to help RIAs file equity ETFs under their own name and brand. 

With its “ETF-in-a-Box” turnkey platform, ETC takes care of all SEC filings and also creates a custom passive index for the fund to track. But it is the RIA who serves up the investment strategy and makes all decisions in the fund.

“The strategy is one they’re probably already running in managing money,” says J. Garrett Stevens, ETC founder-CEO. “We can help them turn the way they’re managing separate accounts into an ETF.”

The firm is in discussion with 50 RIAs and expects to have the first funds trading in late October.  Later: private-label bond ETFs.

Typically it will take ETC four months to bring an ETF to market — only 90 days if the RIA already has a prospectus written or the index put together.

“A private-labeled ETF is a great business model to be in,” Stevens says. “On average, a fund needs about $30 million under management to break even. Assets above that are very profitable.”

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