Some providers of exchange traded funds hold out hope that the government will still turn to ETFs to purchase toxic assets — illiquid real estate loans and securities backed by loan portfolios — from banks.
Right now, the government appears poised to allow closed-end funds to buy the assets as part of the Public-Private Investment Program, which was unveiled last month by the Department of the Treasury. Such funds are considered a good fit for the program because they give managers the ability to invest in illiquid securities without worrying about in-flows and outflows.
But if the government's plan fails — which many industry observers think is a strong possibility — ETFs could get a second look.
"If [the proposal] doesn't have the intended reaction, the government will have to look at alternatives," said Robert Holderith, chief executive at ETF startup Emerging Global Advisors LLC of Ridgewood, N.J.
And the best alternative involves ETFs, said Mr. Holderith, a former managing director at ProFund Advisors LLC of Bethesda, Md.
Others in the ETF industry agree.
At least one major ETF firm was actively lobbying congressional staff members in an attempt to get them to consider a plan using the funds to purchase toxic assets.
It was a hard sell because using ETFs is viewed as complicated, said an executive with the provider, who asked that he and his firm not be identified because of continuing work to create funds that may invest in toxic assets.
An underlying index of toxic assets would need to be created to develop an ETF — a difficult task — unless the ETF is actively managed. Actively managed ETFs, however, are still new, having made their debut just last year, and approval of such products might not be easy.
But if the government's plan fails, it wouldn't be hard to restart a push for a plan using ETFs, an effort that came to a halt when the government announced its plan to buy up toxic assets, the executive said.
FAILURE IS AN OPTION
The failure of the government's plan is a distinct possibility, said Ed Yardeni, president and chief investment strategist of Yardeni Research Inc. of Springfield, N.J.
The Federal Deposit Insurance Corp. and the Treasury Department proposed attracting private capital to purchase eligible loans from participating banks through the provision of
FDIC debt guarantees and Treasury equity co-investments. But the plan doesn't guarantee that banks — which may think that they aren't being offered a fair price — will participate, Mr. Yardeni said.
"It's a very messy proposal," he said. "It's going to take a while to implement."
So what would a plan using ETFs look like?
Under one scenario, the government would make the interest paid on certain hard-to-value mortgage loans tax-exempt in return for a voluntary extension of loan maturities by lenders.
By increasing their after-tax returns, the underlying securities would become more valuable, making it more likely that banks would be willing and able to move at least a portion of these loans off their books and into newly created ETFs.
Because the ETF is a transparent and readily traded vehicle within which the underlying illiquid securities can be valued based upon their cash flows and tax-free yields, it could provide market-based pricing for such securities and the opportunity for profit generation.
The plan has been pushed vigorously by Mr. Holderith and Murray Stahl, chairman and chief investment officer at Horizon Asset Management Inc. of New York.
Horizon is an investor in Mr. Holderith's Emerging Global Advisors.
Critics pointed out one drawback of their plan: At least in the beginning, a price would have to be struck for the illiquid securities before the ETFs could begin trading.
But Mr. Holderith said that using ETFs would still be better than the government's plan because it doesn't rely on closed-end funds.
Closed-end funds have appeared as the vehicle of choice among asset managers who are looking to participate in the government's plan.
Companies that have talked about launching such funds include
BlackRock Inc., Legg Mason Inc. and Pacific Investment Management Co. LLC.
On the surface, the use of closed-end funds makes sense because of the flexibility that they give managers.
'NO ARBITRAGE MECHANISM'
But unlike an ETF, which trades on an exchange, a closed-end fund can trade at a discount or premium to its net asset value.
An ETF sticks closely to its NAV because of its unique creation-redemption process.
"Using closed-end funds is not a good way to build investor confidence. There is no arbitrage mechanism that exists to keep closed-end funds to net asset value," Mr. Holderith said.
"Historically, closed-end funds trade at wide spreads in a normal market," he said. "I don't want to guess what closed-end funds that [invest in toxic assets] would trade at."
Many industry experts agree that the use of closed-end funds is a problem.
For starters, it seems likely that closed-end funds that invest in toxic assets would be sold only to accredited investors via private placements.
But it is hard to see sophisticated investors' taking a shine to them, said Cecilia L. Gondor, executive vice president of Thomas J. Herzfeld Advisors Inc., a closed-end-fund specialist in Miami.
"Closed-end-fund investors are generally more conservative," she said. "I would be surprised if they were interested in this."
Closed-end funds that invest in toxic assets may also be a hard sell given the investor anger that erupted when the market for auction rate preferred securities sold by closed-end funds started to fail in February, said Don Phillips, a managing director with Morningstar Inc. of Chicago.
But because of "liquidity issues" associated with the toxic assets, closed-end funds appear to make the most sense, he said.
Although they may seem risky to most investors, closed-end funds could attract opportunistic investors willing to bet that beaten-down real estate loans will recover, Mr. Phillips said.
Some investors are already sensing an opportunity, said Jack Ablin, chief investment officer of Harris Private Bank, a unit of Harris Bankcorp Inc. of Chicago.
"I'm getting inquiries from clients," he said.
As a result, Mr. Ablin said, "we're actively looking for opportunities for them."
E-mail David Hoffman at [email protected].
