Improving The Actively-Managed ETF Structure
Wednesday, June 16th, 2010ActiveETFs | InFocus writes:
There are many firms out there that are trying to perfect the structure that is currently being used to launch actively-managed ETFs, in order to reach a largely untapped market. There was a lot of fanfare when the global ETF industry crossed the $1 trillion assets mark in 2009. But looking at it from a larger perspective, nearly all of those ETF assets are passively managed and passively-managed assets make up only 10-15% of all assets managed. Meaning that 85-90% of all assets, which are actively-managed, had not even been tapped on yet by ETFs because any investor looking for an active strategy had no choice but to go with a mutual fund. But Active ETFs now allow issuers to reach that much larger “actively-managed†segment of the market.  Hence, as with any new product innovation, changes are being made constantly as issuers experiment and test out new variations in an attempt to find the right structure suitable for delivering an active strategy to investors.
Big Concern: Daily Disclosure
One of the biggest problems that issuers have had with packaging active strategies into Active ETFs is that the managers behind the fund are quite reluctant to provide the level of holdings disclosure that is required by actively-managed ETFs. In the United States, the regulations require Active ETFs to provide daily disclosure of holdings, albeit with a one-day lag. This means that any active manager utilizing a unique investment strategy will be forced to reveal their strategies to the wider public, which could lead to other managers imitating the change in holdings and hence duplicating the active manager’s value-add. Don Suskind, Head of ETF Product Management for PIMCO, echoed this point in his interview with ActiveETFs | InFocus, saying that investors “may not want actually want the portfolio to be disclosed every day because there is risk that that could detract from the return potential of the fundâ€Â.
Another big concern for managers behind Active ETFs is the potential for front-running. Prop desks and traders would love to be able to see the moves that a large active manager makes on a day-to-day basis because they can attempt to make profits by front-running the manager. This is not as big of an issue when the fund is small in size, and the manager’s trades have little impact on security prices. But the moment any fund reaches a respectable size, traders can definitely anticipate the market impact and trade ahead in situations where the manager has to build up a position over several trading days. Richard Weil of Janus Capital voiced his concern on this issue saying, “If we are managing a fund and we want to manage that as an ETF, we would have to disclose our buys and sells everyday and we are concerned that might compromise our fiduciary duty to shareholders. I think the actively-managed ETF business needs to go through some further structural, generational changes before it’s a good vehicle for truly active strategiesâ€Â.
So quite clearly there is some debate on the fairness of the daily disclosure requirement for active managers and a call for change. For inspiration on how Active ETFs can be improved, it’s a good idea to look at how actively-managed ETFs in other countries and regulatory regimes are structured differently.
Modifying Disclosure Requirements
In approving the first few actively-managed ETFs in the US, the SEC took the approach of assessing Active ETFs primarily as “ETFsâ€Â. And since most existing ETFs do provide investors with daily disclosure of holdings, that requirement was carried over to Active ETFs.
Canada:
Looking north of the border to Canada though, where the Active ETF market is still in its early stages with only one provider of actively-managed ETFs, the regulators have also taken a different approach. In Canada, actively-managed ETFs are not required to provide daily disclosure of holdings. The only requirement from the regulators is to provide complete disclosure of holdings every 6 months or semi-annually. However, the one provider of Active ETFs in Canada – Horizons AlphaPro – has chosen to provide more frequent disclosure, revealing their top 25 holdings quarterly and their top 10 holdings every month. In comparison, actively-managed mutual funds usually reveal holdings only every 90 days. So essentially, where the SEC chose to assess Active ETFs as an “ETF†first and an “active fund†later, in Canada the regulators have instead dealt with Active ETFs by considering them to be funds with active managers behind them first. As a result, the disclosure requirements for actively-managed ETFs in Canada are not much different than the disclosure requirements for actively-managed mutual funds.
The natural question that arises in a set up like this is how the ETF’s share price avoids large premiums and discounts versus the real NAV if disclosure of holdings is only made monthly. According to AlphaPro, only the market makers and designated brokers for the ETF do in fact have clear knowledge of the component holdings in the fund on a daily basis, so that they can keep the fund price close to NAV.
Germany:
In Germany, the first company to launch an actively-managed ETF back in 2000 was Deutsche Bank’s DWS Investments. They released 11 different actively-managed ETFs which did not disclose holdings on a daily basis, but provided an accurate NAV price for each fund, based on which trading would take place in the ETF shares the following day. However, market makers for the ETF were again given access to information about the component stocks in the fund so that they can arbitrage to keep the fund price as close to the NAV as possible.
Transparency versus Preserving Manager Interests
While the need for transparency in all types of investments has been in high demand, the concern on the part of Active ETF managers is also legitimate. The structures adopted for actively-managed ETFs in Germany and Canada definitely provide the active managers with more “coverâ€Â, but investors are still able to benefit from all the other advantages of Active ETFs over active mutual funds – lower cost, tradability, tax efficiency.
Ultimately, the SEC will have to consider whether it is should treat Active ETFs, from a regulatory perspective, just as it would a pure index ETF or should they be seen as closer “in purpose†to actively-managed mutual funds. Is it reasonable to impose every single requirement that existed for passive ETFs onto another product that is intended for a completely different purpose and strategy? Investors are already getting a lot of benefits out of Active ETFs, compared to active mutual funds. If the SEC’s sides with the active managers on the disclosure issue, it might well do a lot to encourage growth in this new space.
Disclosure: No positions in above-mentioned names.
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