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Actively managed ETFs: growth area or passing fad?

Outperforming market indices is the signature of success

By Imran Ahmed quantitative funds typically follow indices such as the S&P High Yield Dividend Aristocrats Index. The index measures the performance of the 60 highest dividend yielding members of the S&P Composite 1500. To be included in the index, these companies must also have consistently increased dividends every year for at least 25 years. The WisdomTree Managed Futures ETF or WDTI is an example of a rule-based ETF. The $211 million ETF, launched in January 2011, uses quantitative techniques to invest in investments linked to a combination of fixed income, currencies and commodities. WDTI is a total return product which uses both long and short strategies.5 Surely, PIMCOs $1.3 billion MINT ETF 6 operates with a proprietary investment process which is likely rules based. However, like an actively managed mutual fund, these portfolio management rules, which constitute the ETFs investment process, are not fully transparent to the average investor. The average portfolio duration of MINT will vary based on PIMCOs economic forecasts and active investment process decisions.7 Other than giving ETF manufacturers and investment advisers another product to sell, are there any benefits to actively managed ETFs? Certainly, if mutual fund managers are able to replicate the performance of wellregarded mutual funds, then the benefits include lower costs and increased trading flexibility. As an example, if an investor in a Fidelity Magellan ETF8 can obtain the same performance as an investor in the Fidelity Magellan open-end mutual fund, then the ETF investor profits from a lower expense ratio and an ability to trade the asset in real time. However, ETFs have certain characteristics which may make it challenging for investment managers to perfectly replicate their mutual fund counterparts. ETFs require full transparency in the form of a daily statement specifying all position

xchange traded funds (ETFs) 1 began life as a logical successor to the traditional open-end mutual fund. Since the first ETF was launched in 1993, ETFs have focussed on providing low-cost alternatives to actively managed mutual funds. The basic strategy employed by ETFs has been to replicate major indices and keep transaction costs to a minimum. The savings are passed on to ETF investors. Although ETFs may be mainly about saving investors money, ETFs must also make money for their manufacturers, especially if the industry is to thrive. Consequently, ETF manufacturers have actively sought ways to increase the appeal of their products.

$ Invest Grade Corp Bond ETF, showed assets of $14.2 billion.3 Unlike the foregoing standard ETFs, actively managed ETFs have had a much harder time gaining traction from investors. IndexUniverse, an independent firm tracking the ETF industry, calculates that just over $6 billion in assets are invested in active ETFs. In a $1 trillion plus industry, $6 billion translates into just about 0.5% of the total US listed ETF assets at the end of August 2011.4

Definition
What exactly are active or actively managed ETFs? Simply stated, an active ETF has a portfolio manager(s) who makes decisions which affect the

From simple US index instruments, ETFs have moved into areas such as commodities, international equity, fixed income and actively managed portfolios
Traditionally, ETFs were a medium for investors to obtain market return. ETF portfolios were designed to provide a beta of one relative to an ETFs underlying index and/or strategy. For example, the SPDR Standard and Poors 500 (SPY) return correlates closely with the return of the S&Ps 500 Index of US stocks. From simple US index instruments, ETFs have moved into areas such as commodities, international equity, fixed income and actively managed portfolios. Investors are aware of the success enjoyed by commodity ETFs. GLD and SLV, ETFs designed to track the spot price of gold and silver respectively, alone listed net assets of US$78.7 billion recently. 2 Investors have also been receptive to international equity and fixed income ETFs. EEM, the iShares MSCI Emerging Index ETF, recorded assets of $38.4 billion while LQD, the iShares iBoxx 6
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construction of the portfolio held by the ETF. This human intervention can be active portfolio management of the sort normally practiced by mutual funds, including market timing or sector allocations. ETFs which employ a quantitative, rule-based investment process not linked to a publicly available index also qualify as actively managed. PIMCOs Enhanced Short Maturity Strategy ETF (MINT ), launched in November 2009, is an example of an actively managed ETF. PIMCO manages MINTs portfolio to maximise current income and preserve capital. MINT competes directly against money market mutual funds. Placed in a sort of purgatory for active ETFs are entities that replicate indices which are themselves rulesbased and require occasional but regular modifications to portfolios. These

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the passive or commodity category. Few actively managed ETFs have successfully competed with index tracking ETFs like SPY or DIA. Some observers suggest the most successful actively managed ETF, PIMCOs MINT, has thrived due only to the current low interest rate environment which encourages certain fixed income investors to chase yield. Others attribute MINTs success to the rock star appeal of PIMCOs Bill Gross. Despite these two advantageous factors, PIMCOs Enhanced Short Maturity Strategy ETFs (MINT) $1.3 billion of assets, pales in comparison to ETFs such as SPY. The future of actively managed ETFs is intertwined with a larger philosophical debate taking place amongst money managers: can active managers outperform market indices? Unless the answer is a resounding Yes, then actively managed ETFs will continue to play a peripheral role in the ETF world for some years to come.

details. Clearly, many investment managers will hesitate about revealing their portfolio positions without a reasonable time lag. Analysts parsing through an active ETFs daily statement may easily decipher the managers investment strategy and profit from the information through front running, etc. The daily statement is necessary for Authorised Participants (APs) to maintain smooth operations of any ETF. APs are institutional investors authorised to buy and sell ETF creation units directly with the fund company. It should be noted that several ETF providers are in discussions with the US Securities and Exchange Commission about mechanisms to bypass the public disclosure requirement while still maintaining the integrity of the ETF trading system. All classes of investors have learnt to appreciate the benefits of ETFs. Active traders like an ETFs trading flexibilities while passive investors profit from low
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The future of actively managed ETFs is intertwined with a larger philosophical debate taking place amongst money managers: can active managers out perform market indices
expense ratios. Institutions like the transparency associated with ETFs and retailers the fact that ETFs are traded like ordinary common stock. However, thus far the majority of assets garnered by ETFs have been in

For the purposes of this article, the generic term ETF refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs). As of July 31, 2011, reported by Yahoo Finance and accessed on September 5, 2011. As of July 31, 2011, reported by Yahoo Finance and accessed on September 5, 2011. BlackRock Plans Nontransparent Active ETFs, Olivier Ludwig. September 1, 2011. Accessed on September 5, 2011. http://finance.yahoo.com/news/BlackRock-Plans-indexuniverse-3197678872.html?x=0&.v=1 As of July 31, 2011, reported by Yahoo Finance and accessed on September 5, 2011. As of July 31, 2011, reported by Yahoo Finance and accessed on September 5, 2011. From PIMCOETFS website. Accessed on September 5, 2011. http://www.pimcoetfs.com/FundInfo/Pages/PIMCOEnhancedShortMaturityStrategyFund.aspx The author is unaware of the existence of a Fidelity Magellan ETF. The example is used merely to illustrate a point.

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