Passively managed exchange-traded funds based on equity indexes, in particular SPDRs and Diamonds, have become a fixture in the investment world, and so popular they were literally the salvation of the once-moribund American Stock Exchange (see Indexes, Jul.-Sep. 1999).
In the distance, however, there is the possibility of another new product "dangling out there," to quote Amex representatives, and so far they aren't in on it.
The logical next step, according to several market participants, is to take the exchange traded fund to the next level and introduce actively managed ETFs based, say, on popular, actively managed mutual funds. However, Clifford Weber, senior vice president of product development at the Amex, for one, says that actively managed ETFs are a long way from hitting the exchange. The possibility of trading those funds is currently just something that Amex is looking at, he said, and there are no definite plans being made. He said such products are over a year away from realization at the very least.
According to Gary Gastineau, former senior v.p. of new product development at the Amex and now an asset manager with John Nuveen & Co., the potential products are "not anything that's going to be a massive success," and "It's just something that's going to take a long time to get out there."
However, some people are pursuing the idea a bit more aggressively than the Amex. They are the first to admit that what may seem like a reasonable idea has a lot of design problems to resolve.
Gus Fleites, a principal at State Street Global Advisors, one of the fund companies interested in developing actively managed ETFs, and the manager behind the SPDRs, said one big challenge would be transparency. While everyone knows what's in an index fund, most active managers prefer to keep their positions secret.
"If you think of the traditional ETF, every morning we publish to the world what it is that we're willing to take in and what we'll deliver in kind for creation-redemptions," Fleites said. "If you think about it from an active perspective, why would an active portfolio manager want to communicate to the world beforehand what it is they're looking to buy and what they're looking to sell?"
NAMING ITS PRICE
This also relates to the problem of how to provide intraday pricing on such a product.
"One of the beauties of the index-linked product is from a transparency point of view, everyone knows what's in the fund and that allows everyone to know what the value of the fund should be throughout the day," Fleites pointed out.
That won't work with an actively managed product, so the question remains as to what the mechanism is going to be for pricing an actively managed ETF intraday, he said. This is an even more complicated issue if the fund is not completely transparent, and is being actively traded during the day, since the marketplace needs to be kept up-to-date on any changes.
"I know the people who are interested in doing actively managed funds are trying to come up with some kind of compromise where the basket would not be the exact replica and so forth. I'm not sure that would work," said Nathan Most, who was senior vice president at the Amex and one of the key figures in the development of the SPDRs, the original ETFs.
Most believes it would be possible to construct an actively managed ETF if cash was deposited into the fund and the fund bought the shares, rather than having shares deposited directly into the fund itself. However, he says, this would take away the ability to do an arbitrage and a key advantage of the product would be lost.
There are other problems with actively managed ETFs beyond the main issues of structure and transparency. For one, there's the question of who will buy these products.
Investment professionals have contributed significantly to the trading volume of index-linked products, using them for hedging purposes and, in the case of index fund managers, to round out their portfolios.
"One of the reasons the SPDRs have been so successful is because market makers, brokers, (and) specialists use them to manage their books, to manage their risk, to structure client portfolios," Fleites said. "What's going to encourage a broker to use an actively managed product for risk purposes or risk management?" Explained Fleites, "The natural source of liquidity for the exchange product is the brokers and the specialists doing arbitrage transactions. That may be absent with an active product. So you may not have the liquidity that is so important to these products if you offer it in an active flavor."
He believes the actively managed ETFs will appeal to day traders and to online investors who want to invest their money quickly and easily.
"They might look at their account at three in the afternoon and decide that they need to have exposure to this fund. Rather than wait and go through the hassle of contacting the mutual fund company and buying the share through them, they can just put an order through their broker and buy the position," Fleites said. Furthering the appeal of buying funds through an exchange rather than a fund company would be the ability to get quotes on the fund and keep track of it throughout the day.
Most is convinced there is a market for actively managed ETFs if the structural problems can be worked out. "I think there are probably a lot of people who would buy (an actively managed ETF). Previously, when there was very clear evidence that the indexes were beating the managed funds there were a number of people who would say 'Why are you going for these things? Why are you buying individual stocks?' The answer is 'Well, I enjoy it more; I get more fun out of it,'" he said. Most added that while he believes it has been proven that indexes beat active management over long periods of time, there are some funds that can beat an index over the short term.
Gastineau agrees with Fleites' assessments as to the probable trading volume of such a product.
"These things are highly unlikely to trade in anything like the volume relative to the assets of the fund that you have with the SPDRs or the Nasdaq 100," he says.
HOW IT MIGHT BE DONE
However, Gastineau says there is a good chance that the assets invested in the new funds will exceed those in the indexed ETFs, since actively managed assets still make up the bulk of mutual fund assets. In addition, individual investors currently hold the majority of the assets in existing ETFs, he said, while investment professionals account for much of the trading volume. The fund's lack of attraction for investment professionals will mean smaller trading volume and not necessarily a significant assets shortfall according to Gastineau.
But curious investors should look for enhanced ETFs to arrive on the marketplace before the appearance of any that are fully active.
"It's a product evolution where you start off with the easy products first -the index products - then you gradually go to the enhanced products which are related to the indexes. Then, from there, you move to the active," said James Pacetti, president of ETF International Associates, a consulting firm in New York that specializes in ETFs.
He noted that there are some enhanced ETFs in registration with the Securities and Exchange Commission right now. Gastineau, however, says that those funds do not meet everyone's definition of enhanced.
"I think the SEC is looking at them as if they are (enhanced index funds); I would pretty much call them straight index funds," Gastineau said. "I think that's something you could pretty much say is an issue of semantics."
Some of the funds in registration might utilize active strategies, but all are designed to track or match the performance of an index, Weber agreed.
Fleites also believes that enhanced ETFs are the next phase. "I think personally that the next wave is going to be an enhanced index product, because there you still preserve a lot of advantages of the original index-linked investment product. People will go to it because it offers the potential to earn a little bit more money, but the concept is still by and large the same." Further, brokers will still find an enhanced ETF an attractive hedging tool, he added.
The first fully actively managed ETFs, however, might be issued as additional share classes of regular mutual funds, Pacetti says. "Alot of people who are looking to do ETFs want to take an existing fund they have and create a new class of shares with the ETFs."
Gastineau and representatives of the Amex stress that the actively managed ETF is still in the very earliest stages of development.
Even if all the structural issues are worked out, he believes the funds will still be a long way from being brought to the marketplace. The Securities Exchange Commission took a long time to approve the original ETFs, and Gastineau believes they will take at least as long when they turn their attention to the actively managed ETFs. "Down the road it could be very interesting, but there's really not that much to talk about [yet]," Weber concluded.