The New Wave of Active ETFs

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.