Getting Hands-On

Over the past several years the exchange-traded funds industry has attempted to bring actively managed funds to market without much success. But a reversal of that losing streak looks likely.

After years of bureaucratic delays with the Securities and Exchange Commission and other technical problems, the first generation of active ETFs appears ready to make an impact.

In February, the SEC issued a notice that it expects to grant the legal exemptions needed to pave the way for PowerShares Capital Management to launch four proposed active ETFs.

The initial filing covers three equity funds and one fixed-income fund. AER Advisors, an affiliate of the New Hampshire-based stock research company Alpha Equity Research, will manage the funds.

Regarding one of the proposed active funds, called the “AlphaQ Fund,” the SEC filing describes AER’s investment methodology: “to achieve returns in excess of the Nasdaq 100 Index by focusing on the stocks within the Q Universe identified through its ‘NOW’ ranking system as strong performers and avoiding or eliminating from the Fund’s portfolio stocks which are identified as weak performers.”

The NOW ranking was developed by AER in 1998 to combine the quantitative aspects of stock money flow with traditional fundamental security analysis. Each week, AER tracks the volume-weighted price movements of all stocks in the universe with a four-week distributed average relative to the issuer’s public float and expressed as a range from 1-109. This range is called the “Alpha Score” and allows investors to compare the relative buy pressure of each stock on the master stock list.

Actively Managed? Says Who?A closer look at the active ETFs from PowerShares reveals a close resemblance to the company’s Intellidex index funds, which follow a similar strategy of quantitative stock selection. These similarities have caused some observers to question the claim that the PowerShares ETFs are truly actively managed.

Will McClatchy, editor of ETF-zone.com comments that the AlphaQ Fund “clearly falls within the universe of fundamental ETFs.” He adds, “In practice AER performs the same tasks as an index provider by creating a methodology and using it to pick and weight stocks. I would argue that there is in fact an index being calculated in the back office at AER; it’s just not releasing it and calling it that.”

The fact that the AlphaQ isn’t tied to a benchmark index is still reason enough to call it active.

Nevertheless, fund investors accustomed to portfolio managers with a team of research analysts that buy and sell securities whenever they want, may be disappointed by the first generation of active ETFs. The latter are governed by strict quantitative formulas and rely more on number crunching than manager wit.

In order to appease securities regulators, the PowerShares funds will be limited to placing portfolio trades on certain dates and they’ll need to provide investors with frequent information about underlying holdings.

The nature of these restrictions isn’t common to most active funds, which have considerably less transparency.

Overcoming BarriersA long-time stumbling block for actively managed ETFs has been the issue of disclosure and transparency.

Since ETFs have intraday liquidity, disclosing a fund’s holdings is necessary in order to calculate its real-time net asset value. Such transparency raises the possibility of front-running portfolio trades by market speculators and traders looking to make a quick buck. Front running would clearly have a negative impact on ETF shareholders by artificially boosting share prices and creating undesired volatility. With actively managed mutual funds these problems are minimized because portfolio managers tend to reveal their holdings with less frequency.

Another issue relates to the creation of ETF shares. During the share creation process, a large financial institution will typically deliver securities in the underlying index to the fund company. For example, an institutional investor would have to deliver all 500 stocks in the S&P 500 in order to receive ETF shares in the SPDRs (SPY), which track this index. When shares are redeemed, this process is reversed. It’s this creation/redemption process of shares that are a crucial element to the behind the scenes mechanics of ETFs.

With active ETFs, how can ETF shares be created if investors don’t know what specific securities that fund managers own? Knowing the underlying holdings is a prerequisite to creating ETF shares. It remains to be seen whether the creation/redemption of shares in actively managed ETFs will be as smooth as it has been with index ETFs. What about the market price of actively managed ETFs? Will it deviate widely from the fund’s NAV?

With index ETFs, large discrepancies in a fund’s market price and NAV are rare, but no one knows how active ETFs will fare. If significant differences in the market price of ETF shares relative to their underlying NAV manifest themselves, active ETFs could end up resembling closed-end mutual funds which are notorious for trading at persistent premiums and discounts. During market extremes the integrity of actively managed ETFs will be put to the test.

Looking AheadEven with all their promise, active ETFs will have to overcome many obstacles. One of the most significant of these will be a lack of any performance history. Investors in active funds typically rely on a portfolio manager’s track record before determining if they want to invest. Will investors be eager to put money into active ETFs with no proven performance?

Additionally, it will take active ETFs at least three years of performance history before they can be rated by mutual fund analysts like Morningstar. In the meantime, they better hope they can achieve eye-popping performance.

Despite these hurdles, the introduction of active ETFs is a major step for the $600 billion ETF industry. Many experts agree that ETF investment strategies will have to expand beyond indexing in order to rival the much larger $12 trillion mutual fund industry. Even though they’ve been constrained to index strategies, ETF assets have still managed to increase by more than 40 percent since the end of 2006.

With the arrival of active ETFs, fund providers are already calculating even greater asset growth. For prepared financial advisors it presents another window of opportunity to attract and retain more clients. Are you ready? o

Over the past several years the exchange-traded funds industry has attempted to bring actively managed funds to market without much success. But a reversal of that losing streak looks likely.