2010 Year in Review: 1 Big Positive Development and 3 Hurdles for Active ETFs

In 2010, actively-managed ETFs in North America have generated a lot of buzz, investor interest as well as interest from the manufacturers of financial products. At the end of 2009, Active ETFs were still being seen as more of an experiment by some fund managers, trying to explore a new niche in the ETF landscape. That perception is starting to change, primarily because of growing issuer interest.

The Positive Development: Continuing Issuer Interest

We started off 2010 with a total of 22 actively-managed ETFs, with the major players being WisdomTree with their active currency ETFs, PIMCO with their active bond ETFs, Grail Advisors with a series of conventional active equity ETFs and PowerShares which had both active equity and bond ETFs. At that time, all the existing players in the Active ETF space were themselves quite new to the arena with half the existing funds having been launched only in 2009.

Today, nearing the end of 2010, there are 33 actively-managed ETFs with close to $3 billion in assets, from 7 different issuers. While the size of the asset base is still nothing to gloat about, issuers and investors are slowly seeing that Active ETFs could well hold their own amidst the explosive growth that the ETF industry is experiencing as a whole. The biggest change over 2010 that supports this notion has been the growing line of fund companies that have expressed interest in the Active ETF space by filing exemptive relief applications with the SEC to launch actively-managed ETFs in the US. The table below shows the 26 money managers with applications for actively-managed ETFs with the SEC. Just the ratio of prospective issuers to the number of existing issuers – 26 to 7 – tells you about the level of interest in the space.

What’s telling is the kind of companies that have expressed an interest in this space. These are not small time firms that are just shooting an arrow in the dark and experimenting to see if they land on something interesting. Many of these companies are large mutual fund houses – T. Rowe Price, Legg Mason, Eaton Vance, PIMCO – and major financial firms – Goldman Sachs, JP Morgan, Huntington – that would not be putting their reputations at stake by jumping into the latest new “fad”. So while new asset gathering has been slow within the Active ETF space, it is the presence of firms like these waiting on the sidelines that is encouraging for the industry as a whole. Even if a few of them follow through on their plans to launch actively-managed ETFs, the brand power, marketing strength and distribution leverage that they bring will provide a definite boost to the Active ETF space in attracting investor interest and assets.

Ultimately, players on the fringes are seeing Active ETFs as an opportunity to build on each of their strengths. Existing ETF issuers like PowerShares, Vanguard and BlackRock iShares clearly see this as a chance to expand their ETF manufacturing capabilities beyond passive strategies and into actively-managed funds. Large mutual fund players like Eaton Vance and PIMCO see this as a chance to participate in the explosive growth in the ETF industry in an area which they already have an expertise in – active management. And large financial firms like JP Morgan will likely want to use their brand power and strong distribution networks to make a strong entrance into the ETF market.

The Continuing Hurdles: Regulatory Uncertainty, Transparency and Education

However, one of the things that has continued to keep that ratio of prospective issuers to the number of existing issuers high is the snail’s pace at which the SEC has approved the launch of these products. In March 2010, the SEC announced the start of a review of derivative usage within ETFs, during which time all applications seeking exemptive relief for new ETFs that utilize derivative would be tentatively put on hold. This was a big blow to actively-managed ETFs. While not all Active ETFs utilized derivatives, some used them for risk management purposes while others used them as a more integral part of their investment strategies. Nine months later, the SEC has yet to announce any conclusive findings/results from the review. This has resulted in a regulatory overhang over actively-managed ETFs and how they will be treated by the SEC going forward.

The issue of transparency has been another contentious topic that has been causing ripples in the Active ETF space. The conventional view in the market, especially after the 2008 crash, has been that more transparency is better. By that logic, actively-managed ETFs – which disclose holdings everyday with a 1-day lag, have claimed superiority over active mutual funds – which are only required to provide disclosure once every quarter, with a 60-day lag. However, active portfolio managers have not warmed up to this level of transparency and have cited fears of front-running and leaving their investment strategies open to duplication. At the end of the day, this has discouraged many active managers from launching Active ETFs, despite other potential benefits of the ETF structure. More proactive players like Eaton Vance are now making efforts to find ways to launch non-transparent actively-managed ETFs. The SEC will again be central to this debate and will ultimately have to take a stance on the level of transparency appropriate for actively-managed ETFs.

Another major hurdle that the Active ETF space will face has to do more with the investors themselves. Issuers can launch numerous new ETFs, but if the investors do not understand the merits of the products, they’ll have little incentive to overcome their inertia to invest in a new product. It took passive ETFs more than a decade to develop the kind of awareness they have today among investors. That more retail money is deployed in passive ETFs today than passive mutual funds is testament to the educational efforts from various ETF manufacturers, alongside their marketing efforts. In comparison, Active ETFs have only been around for about 2.5 years now, so by any measure, the educational process is only just starting. The need for education about the benefits of actively-managed ETFs over active mutual funds will be even greater, since the use of active mutual funds is much more pervasive today than the use of passive mutual funds was when passive ETFs were first launched.