Outlook 2011: Four Forecasts For Active ETFs

The big question that the ETF industry faces in 2011 is where does the next trillion come from? The questions surrounding the Active ETF space in particular revolve more around when these products will really take off and attract significant investor assets.

The growth trajectory of this niche segment in the ETF industry remains to be seen. How it all plays out in 2011 depends on the type of new products that come to market, the level of regulatory clarity that the SEC provides with regards to actively-managed ETFs and how much effort new and incumbent players put in to promote and market these products to retail investors.

It’s hard to predict how “the cookie will crumble” for Active ETFs, especially because so many determining factors are up in the air. But here are four forecasts for 2011 nonetheless.

More issuers will attempt to bring non-transparent Active ETFs to market

In the last year, one of the biggest issues that has been raised with regards to actively-managed ETFs is the issue of transparency. For investors and advisors, the consensus is that they prefer greater transparency, even though industry experts such as Gary Gastineau have articulated quite clearly that transparency is not to the benefit of end investors. There are also two sides to the debate from the issuer perspective. Anecdotally, many active managers have decided to stay out of the Active ETF space because they fear giving their proprietary strategies away by complying with daily disclosure of holdings. Other active managers, conversely, especially those who have already made the leap and are running actively-managed ETFs, say that the transparency is not an issue and may even help attract investors to their funds.

Yet, despite the mixed response, some proactive issuers are continuing to make moves to try and bring non-transparent actively-managed ETFs to market. BlackRock iShares had reportedly requested approval from the SEC for an Active ETF that would “that would keep some of their assets undisclosed”. More recently, Eaton Vance acquired the assets and patents of Managed ETFs LLC, a company co-founded by Gary Gastineau, which holds several patents to trading mechanisms that could help non-transparent Active ETFs trade effectively.

Ultimately, this storyline ends with what the SEC decides and if it articulates a clear stance on transparency requirements for Active ETFs. But to make that happen, we will likely see more attempts in 2011 at structuring Active ETFs differently to protect the active manager’s intellectual capital while still being relatively less opaque than active mutual funds.

Active ETFs will enter commodities and emerging market equities

In 2010, we saw new actively-managed ETFs venture into asset classes that ETF investors could only get passive exposure to previously. For example, WisdomTree came out with an Emerging Markets Local Debt Fund that provided access to an active manager focusing on emerging market debt and placing active bets in that sector. We also saw PIMCO come out with its Build America Bond Strategy Fund which invested in Build America Bonds, another area that investors could only get passive exposure to through ETFs before this launch. We also saw several more funds tap into the municipal bonds sector and utilize active management in an attempt to add value.

Despite this, there are still quite a few sectors and asset classes that remain uncovered by Active ETFs. In a survey conducted on ActiveETFs | InFocus, we asked readers “Which investment sectors would active management be most useful in?”, and a majority of readers pointed to emerging market equities. Most investors will agree that someone with knowledge of local markets, companies and business practices in emerging markets would be able to add some incremental value. There is no doubt that this is one area which can benefit from an actively-managed ETF and issuers will likely capitalize on this opportunity in the coming year.

Another area is commodities. Too many investors have been puzzled and bewildered by the complexities behind passive commodity ETFs. Evaluating whether physically-backed exposure or synthetic exposure is better, whether the commodity in question is in a state of contango or backwardation and how that affects their returns – these are all questions that can be quite daunting for retail investors to answer by themselves. Hence, this is also another area where an expert commodity manager to manage your money would come in handy. Several attempts have already been made within passive ETFs to provide more adaptable exposure to commodities through dynamic indices. In the coming year, I’d expect pure active commodity managers and Commodity Trading Advisors (CTAs) to tap on this potential market through Active ETFs.

Three-year track records will help attract more assets to established funds

2011 will be the first time that any actively-managed ETF will achieve a 3-year track record. The oldest batch of Active ETFs is from PowerShares, four of which were launched in April 2008. These four funds will achieve a 3-year track record in April 2011, provided they remain on the market till then. That’s when active funds typically receive their Morningstar ratings.

Right from the early beginnings of actively-managed ETFs, one of the main caveats to the successful adoption of these funds was that since these are actively-managed instruments, one of the most important things that will facilitate their success (or failure) would be whether they can develop a long enough, healthy track record against their benchmark. Ultimately, all the benefits of the ETF structure are irrelevant if the manager is performs poorly.

As a result, achieving a 3-year track record will be a big step for these Active ETFs and should help put these funds on the radar screens of many advisors and investors that would otherwise shun any funds with short track records right off the bat. Next in line after PowerShares’ four funds would be several of WisdomTree’s actively-managed currency funds that’ll achieve a 3-year track record in May 2011.

Issuers waiting on the sidelines will enter the Active ETF space

At the moment there are seven issuers with live actively-managed ETFs on the market. In contrast, there are about 25 different money managers that have filings with the SEC to launch these products. Some of those players have been waiting on the sidelines for several years now, thanks to the snail’s pace at which the SEC has been handing out approvals to those applications.

In 2011, we will likely see many of these firms waiting on the fringes actually launch their products in the Active ETF space and compete head on with the incumbent leaders. There’s little doubt that even if a few of the players from the likes of Eaton Vance, Legg Mason, T. Rowe Price, BlackRock iShares or Vanguard receive the SEC’s green light and successfully launch actively-managed ETFs, existing issuers like PIMCO, WisdomTree and PowerShares will start facing some serious competition.

Practically speaking though, this forecast is more a shot in the dark than anything else because of the inherent unpredictability of the regulatory process. When the SEC announced its investigation into derivatives usage in ETFs in March 2010, the entire space came to a practical standstill. And no conclusive findings or results have been announced from the investigation thus far. So the regulatory overhang continues to haunt the development of actively-managed ETFs and it is anyone’s guess when that will change.