Actively managed ETFs are ready to hit the market. Industry executives and regulators have been talking about this moment for years, as low-cost, tax-efficient passive ETFs surged in popularity. But it’s looking like final approval for the first of the new breed could be just around the corner—maybe even coming by the end of this month.
On Friday, the SEC gave preliminary approval to four PowerShares actively managed ETFs, exempting them from certain securities law provisions. But it left a door open to anyone who wanted to hold a hearing on that exemption, something that can be requested through February 26. Barclays and Bear Stearns are also expected to get preliminary approval on actively managed ETFs soon.
SEC officials have been saying for some time that they would make ETF approvals, particularly active ETFs, a priority. “There was such a big backlog. Sometimes it would take years to get certain ETFs through the approval process,” says Sonya Morris, an ETF analyst with Morningstar. “That’s improved considerably over the last 18 months or two years.”
Will active ETFs spell the demise of the mutual fund industry? Probably not—at least not yet. “It doesn’t seem like these three [equity-based] funds are bringing all that much to the table right now,” says Morris. “It’s not going to be unfettered active management.”
And that’s because the ETF companies still haven’t entirely resolved the issues of transparency and front-running that have plagued them since the beginning. Basically, ETFs are required to disclose their holdings on a daily basis, unlike mutual funds, which usually disclose holdings on a monthly or quarterly basis. The problem with daily disclosure when you’re using active management is that it can encourage front running from other investors, undercutting a manager’s ability to make a profit on his picks.
PowerShares has tried to work around this: Two of its three equity-based ETFs are essentially quant-based equity funds that would allow their managers to trade only on the last business day of every week, and to place up to three trades—trades that won’t be posted until after the weekend. The firm’s third equity-based active ETF allows the manager to place unlimited trades, but its focus is large-cap equities. This part of the market is traded so frequently that it’s hard to front-run; it also means it’s hard to exploit pricing inefficiencies and beat the market. “It’s the hardest place for active managers to add value,” says Morris.
By virtue of the very fact that actively managed ETFs will require, well, more management, they probably aren’t going to be as low-cost as their passive ETF cousins. “I’m skeptical that expenses will be as low as on passive ETFs,” says Morris, referring to active ETFs in general. But she adds that PowerShares’ ETFs tend to be more expensive than the competition.
There is, of course, the tax-efficiency advantage offered by ETFs. Some industry observers worried that using an active trading style inside an ETF would result in big capital gains and losses, eliminating that advantage. Morris cites PowerShares Dynamic Market, which is passively managed but tracks an index that is created using quantitative strategies, is redesigned four times a year, and has north of 100-percent turnover. In the five years since its inception, it has never distributed a capital gain. “ETFs have shown an ability to handle a certain amount of trading,” says Morris.
In any case, it may be only a matter of time before managers work out the other kinks. In the meantime, passive ETFs had a record year last year: ETF assets grew 45 percent to $608 billion while the number of ETFs on the market spiked 141 percent, with 270 new ETFs launched during the year. Demand has fallen off a little bit in the past month, as market volatility spiked.
