Active ETFs: A Conversation with Patrick Daugherty, Partner at Foley & Lardner

In August 2010, ActiveETFs | InFocus spoke with Patrick Daugherty, who is a partner at Foley & Lardner LLP, which is a highly regarded national law firm. Patrick and his team helped launch the very first actively-managed ETF in the United States from Bear Stearns in 2008. Patrick has worked on numerous other ETF launches and deals extensively with the SEC. Patrick chats with us about the challenges in launching the first Active ETF, implications of the daily disclosure requirement and paralysis at the SEC when it comes to new product development.

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Shishir Nigam, ActiveETFs | InFocus: You were involved with the launch of the first ever actively-managed ETF from Bear Stearns in 2008. What were your main challenges in bringing such a novel product to the market?

Patrick Daugherty, Foley & Lardner LLP: There were several. The most memorable one was persuading the SEC and ourselves that we could accurately price the portfolio of debt securities for indicative intraday value purposes. The fixed-income securities, unlike public equities, are not reported in real-time and consequently this was more challenging than has been the case for equity-oriented ETFs. And it required some technological work on the part of other participants in the working group to get it done. And I would say, another point was developing overall confidence, first among the working group and then among the regulators relative to the workability of the product, since it was a new product. There was a long prior history of reluctance to allow these products to proliferate.

Shishir: What is your view on the daily transparency required for Active ETFs? Do you think the disclosure requirements discourage active managers from launching new Active ETFs?

Patrick: There’s no doubt it discourages some of them because sophisticated and active traders whom I speak to, who have been known to do other things that require capital and human resources, have told me that this is the reason they have not gone into this field. I put it that way because it’s easy to say I’m not going to do it for one reason, if in fact there’s another reason. But these are people who have a history of exploiting niches in the market and this is a niche that they have decided to stay out of for that reason. But I don’t think it is a universal phenomenon certainly because we know in fact other actively managed funds have come online and they have stayed open.

Shishir: BlackRock iShares is reportedly in discussions with the SEC proposing actively-managed ETFs with reduced disclosure. Do you think the SEC would consider that idea?

Patrick: I think the SEC should be open to considering that idea. Right now, the agency is paralyzed when it comes to new product development. We are not sure why this is so. We think there is some reluctance to allow additional new products because of the recent unprecedented turmoil in the markets. It’s also the case that the agency has many new mandates that have been given to it by Congress and the President in the last month and is overwhelmed with its new responsibility. So I’m fearful that there is a log-jam at the agency that is holding up important new developments such as this one. But I do believe that the SEC should be open to continued development of actively managed funds. So I hope it will find the ability, time and will to do so.

Shishir: In March, the SEC launched an investigation into derivative usage in ETFs, in response to which many issuers have removed derivatives from their proposed ETFs. How much do you think that investigation has affected the pace of growth in Active ETFs?

Patrick: It’s also had an effect because many funds rely on derivatives to a greater or lesser extent. Some funds rely on them almost exclusively, the inverse return funds, for example, rely on them almost exclusively. But other funds will rely on upon them for at least a portion of their holdings to replicate some piece of the portfolio that is more efficiently held through derivatives. So it certainly has an effect on this industry, and it’s unfortunate.

Shishir: Would you say that the Active ETF filings are ahead of actual product plans and sound investment strategies?

Patrick: Well, there are certainly more funds planned than there are funds launched. And it is usually the case that several funds will be prepared for launch with full expectation that a smaller number of them actually will gain traction and succeed commercially. The reason is that it’s expensive to develop these funds but there is scale efficiency in doing it because the cost of launching 20 funds is nowhere near 20 times the cost of launching one fund. So it is typical to bring several ideas to the market and to the SEC specifically at once and then whittle them out over time. Is it good for investors? Probably not the best thing for investors to be in very small funds because the cost of managing the fund will be prohibitive. There’s a possibility that the fund will have to go out of business – the investor should not lose money in that case but there’ll be some disruption nevertheless. Those are my thoughts about it.

Shishir: What could be a catalyst to kick-start real asset growth within actively-managed ETFs, something that has been missing so far in existing products?

Patrick: I can think of two things. One would be broad adoption of ETFs as an investment option for 401Ks and IRAs, that would be one. We have some of that because we know that iShares is doing this, but it’s not very broad. The other thing would be a technology or political judgement by the SEC that allows less than fully disclosed actively-managed funds to come to market. We talked about that earlier, there’s no doubt that some traders are deterred from coming to market because of the full disclosure requirement.

Shishir: How do you see the Active ETF space evolving in general in the next few years?

Patrick: I think it will grow, but I don’t know at what rate. I’m very bullish on the ETF industry in general and as it turns up, I think actively managed will continue to grow as well. I’m not prescient enough to predict whether the rate of growth for actively managed funds will be higher rather than lower than the rate of growth for the industry generally.

Shishir: That’s fantastic, thanks a lot for taking time out to speak with us Patrick.

Patrick: It’s my pleasure and if I can amplify or clarify any of my remarks I’d like to do that. Thank you for your time.