They may be gaining in popularity, but exchange traded funds are far from the perfect product.
Many are "riddled" with structural defects, said Dan McCabe, chief executive of Next Investments, a Bedminster, N.J.-based firm that specializes in the design and development of tools for the mutual fund industry, ETF providers and other financial services institutions.
Relatively new actively managed ETFs are of particular concern, he said, adding that passive, index-based ETFs are also flawed. That's because many such ETFs are currently susceptible to arbitrage activity, and such activity costs investors in mutual funds, Mr. McCabe said.
For example, due to arbitrage around index changes, investors in funds that follow the Standard & Poor's 500 stock index lose between 0.03% and 0.12% annually, according to a 2006 study in the Financial Analysts Journal. Investors in funds that follow the Russell 2000 Index lose between 1.30% and 1.84%, the study concluded.
At the time of its publication, Russell disagreed with the study's findings. The Russell indexes have lower turnover than the S&P 500, meaning there is less chance to arbitrage them, the company maintained.
That may be true, but arbitrage still goes on, said Mr. McCabe. "The professional community may know an index change prior to a retail investor," he said. That can result in "events that impact the value" of an index fund or ETF, Mr. McCabe added.
The solution is to "try and bring professional trading concepts to retail investors," he said.
Other industry experts, however, said they didn't believe arbitrage is much of a problem.
"There are likely to be small opportunities to be had," said Paul Justice, an ETF strategist with Morningstar Inc. of Chicago "But I wouldn't say it's a huge problem."
Front-running an index is "a process that went on way before the introduction of ETFs," said Tom Lydon, president of Global Trends Investments, a Newport Beach, Calif.-based firm that manages $75 million in assets. But it's not something he sees as a major issue. It probably isn't that noticeable to retail investors, agreed Mr. McCabe.
ACTIVE ETFS
Structural problems associated with recent actively managed ETFs, however, are very noticeable, he said.
Although Mr. McCabe declined to mention them by name, Invesco PowerShares Capital Management LLC of Wheaton, Ill., launched actively managed ETFs earlier this year. Their daily disclosure on a website allows for active management.
The result is that there will always be a brief window in which investors won't know what the ETF holds and when managers can make changes to the portfolios without having to worry about arbitrage.
Active managers will get used to the idea of managing money within such a structure, Bruce Bond, the president and chief executive of Invesco PowerShares, has said repeatedly.
Mr. McCabe, however, disagrees. "No good alpha provider will do that," he said.
Neither could they agree about another idea that's been much discussed: the creation of a proxy portfolio.
The proxy portfolio — an idea floated by American Stock Exchange LLC in New York — would allow for intraday pricing without investors actually knowing the exact trades being made by the fund.
"I have always disagreed with the idea of giving information that is not accurate," Mr. McCabe said.
Next Investment has developed its own actively managed ETF solution — ActiveShares.
Mr. McCabe declined to provide specifics on how ActiveShares would address what he sees as the weaknesses of other actively managed ETFs.
It's a safe bet, however, that debate over ETF structures won't end with ActiveShares.
The Securities and Exchange Commission has "loosened" the rules around ETFs to allow for the development of actively managed ETFs, said Mr. Justice. As a result, investors will likely see many active ETF structures, as well as new twists on the traditional, passive structure, he said.
E-mail David Hoffman at [email protected].
