For years, the advice industry has been hearing about a coming wave of actively managed exchange-traded funds. Yet as each year passes, very little happens.
Out of a total universe of 1,366 exchange-traded funds, the asset management industry has launched only 84 actively managed ETFs, according to Morningstar Inc.
"Active ETFs represent about 1% of the overall ETF market, and roughly half of those active-ETF assets are concentrated in two funds managed by [Pacific Investment Management Co.]," said Stephen Clarke, president of Navigate Fund Solutions, an Eaton Vance Corp. subsidiary that was created specifically to develop a new active-ETF model.
In an otherwise vibrant ETF market, why isn't the active side keeping up?
The party line against the creation of active ETFs by mutual fund companies typically boils down to those pesky rules that require daily portfolio transparency in the active-ETF format. But some critics say the real reason is that the industry wants to protect the higher management fees it is able to collect for mutual funds compared with ETFs.
In 2008, when the Securities and Exchange Commission initially approved active ETFs, the stipulation was that the portfolio holdings had to be disclosed daily. Before 2008, the ETF industry was made up entirely of index-based strategies, and portfolio transparency was never an issue.
SHOWING YOUR HAND
A growing voice from the mutual fund industry is claiming that managing an active ETF would give the world a free look at what portfolio managers were doing inside their funds. Daily disclosure is a far cry from what the mutual fund industry has gotten used to in the form of quarterly portfolio transparency requirements, reported on a 60-day lag.
"The fund companies say they're concerned about shadowing and front running of their portfolios, although we think both of those issues are overblown," said Robert Goldsborough, an ETF analyst at Morningstar.
"You have some enormously talented active managers at the mutual fund companies, but they're also very paranoid," he said. "The portfolio disclosure issue has become sort of a psychological hurdle."
That hurdle has led to a long and growing list of mutual fund companies appealing to the SEC for permission to launch less transparent variations on the active-ETF model.
Some of the firms applying for portfolio disclosure exemptions include well-established ETF players such as BlackRock Inc., Guggenheim Investments and State Street Global Advisors. But other firms such as Eaton Vance and T. Rowe Price Group, which aren't even in the ETF business, have also applied for exemptions. The reason may be the size of the ETF industry and its potential down the road.
The fast-growing ETF industry already has $1.7 trillion in assets. ETF.com in January predicted that within 10 years, total ETF assets will reach $15.5 trillion and eclipse the size of the mutual fund industry.
"That $1.7 trillion is the number the fund companies are looking at today, because the growth in [index-based investing] over the last 10 years has been predominantly in ETFs," said Jim Ross, executive vice president at State Street.
"I think it's hard to predict how big the active-ETF space will be," he added, "but we have seen the appetite among advisers for targeted active-ETF strategies."
SSGA already offers more than 130 ETFs, including a few active ones, but the company still has filed with the SEC for permission to launch a nontransparent active version.
"Full transparency hasn't proven to be a significant challenge for existing active ETFs," Mr. Ross said. "The thing that's yet to be proven, and the big 'if' on SEC approval, is whether the nontransparent versions even work."
While the mutual fund industry pleads for exemptions to protect its intellectual property, regulators and critics warn that masking portfolio holdings will lead to wider spreads and other challenges as ETF market makers try to hedge their exposure while taking on the added risk of not knowing exactly what they are trying to hedge.
The SEC did not respond to a request for comment on whether it would grant disclosure exemptions to any of the asset managers that have applied for them. Mr. Goldborough believes the regulator will ultimately allow some form of masked portfolios for some active ETFs.
Eaton Vance's Navigate unit is seeking transparency relief for a hybrid fund, which might be more mutual fund than ETF.
Dubbed an exchange-traded mutual fund, the Navigate model would trade like an ETF all day long but price only at the end of the day like a mutual fund.
"Our approach is an investment vehicle, not a trading vehicle," Mr. Clarke said. "We look at it as an evolution on the theme of the mutual fund."
Even if it does get through the regulatory gantlet, such hybrid active-ETF strategies still likely will end up going head-to-head with pure active ETFs.
Some managers don't sweat the daily disclosure of holdings.
"An active ETF doesn't need to be nontransparent," said Noah Hamman, chief executive of AdvisorShares Investments. "We looked around and we couldn't find any research that said if a portfolio doesn't show its positions, it will produce better alpha."
AdvisorShares launched its first active ETF in 2009 and has since grown to 24 active ETFs and $1.5 billion under management, $500 million of which has come in since January.
'BRING IT ON'
On the issue of portfolio transparency and the threat of other traders' trying to invest based on published portfolio holdings, Mr. Hamman says bring it on.
"If you like what I'm doing so much, don't just try and trade based on what you think I'm trying to do — just buy my fund," he said. "If somebody is trying to copy what I'm doing, chances are, they're getting far worse prices than I'm getting."
Mr. Hamman also shoots down arguments that if it takes a portfolio manager a few days to unwind a large position, the transparency factor could drive the stock price down before the entire position is sold.
"If other investors see me unwinding a position and follow suit, that could push the stock price down to a level where I don't want to sell anymore," he said. "There's no rule that says I have to keep unwinding if a stock price drops down to a more attractive level."
As Mr. Hamman sees it, the biggest reason why more mutual fund companies aren't aggressively entering the active-ETF sector is that fund companies can still charge higher management fees for mutual funds than they can for ETFs.
"Active mutual funds are not going anywhere soon, because commission-based brokers and advisers are still feeding that space," he said. "That's one thing a mutual fund does a much better job at than an ETF — charging fees at the individual level through multiple share classes."
Mr. Clarke doesn't agree with Mr. Hamman. In fact, he claimed he had never heard that argument before. He said that from the investor's standpoint, the focus should be on better performance in a better structure.