Are These Active ETFs?

December 03, 2007

A close-up look at what really makes an "active ETF" an "active ETF."

I've found something else I don't believe Matt and I agree on. When the new Powershares Active ETF prospectus hit, Mr. Hougan ran a splashy story on it. I immediately messaged him and we debated.

Are these "active" ETFs? active "ETFs?" Exchange-traded products with an activist proclivity? It's so confusing. Leave it to Mr. Bond and his band of merry product launchers at PowerShares to keep us all on our toes.

There is so much gray zone here, it's like London in a San Francisco fog. First let's work on getting some terms straight. Because let me tell you, words in this business are thrown all over the place with wildly different definitions attached to them.

Exchange-traded fund: An ETF is a mutual fund that trades like a stock and is based on an index. Its shares can be created and redeemed in baskets of stock that keep the trading price close to the NAV. There are a HOST of exchange-traded products on the market that do not meet this definition in my view. The gold ETFs? They're actually the gold ETPs (exchange-traded products), and the same goes for the commodities funds, the leveraged and inverse funds, etc. They all DO deserve to be in the same general class, because the underlying is run on fixed rules and the creation/redemption process does effectively have the fund returns tracking the underlying NAV (as opposed to an exchange-traded closed-end fund, with the added twist that Nuveen claims [probably correctly] that they've been using the term ETF for their closed-end funds for years. But in my definition, anything running a 15% premium or discount can't be an ETF).

Index: This would seem like the most simple of all terms to define, right? You have got to be kidding me. In Hong Kong last week, some guy tried to convince me that my 3-year-old son Guillermo was an index. Good lord. This is where all the troubles started. And again, what an index IS might have been preserved if it wasn't for Mr. Bond and those meddling kids at PowerShares. Actually, the definition of an index had been thrown into the obfuscated gray well before PowerShares, but they helped cement that fate. "Indellidexes" indeed.

So what is the Jim Wiandt First-Class definition of an index? An index is a grouping of underlying components that is meant to represent an asset class (read beta of an asset class). It has a fully transparent methodology and fully transparent underlying components. That is it. If you are trying to outperform an asset class, you are not an index ... you are a "quantitatively driven index" or an "active index."

So I've been saying for years that there are ALREADY active ETFs on the market, lots of them. And the Intellidexes are among them, as are FTSE RAFI PowerShares, the new SPA "indexes," the Alpha Shares and any number of these other newfangled products.

This is a real purest definition, I recognize, and it puts me out there on a limb. Indeed, you could even argue under my definition that the S&P 500 and DJ Industrial Average (which is not really an "average" by the way) are not truly indexes because their underlying is picked by a committee.

Did I mention we'd entered the gray zone?

Beta: Oh man, this is one of my favorites, because the term "beta" is thrown around all over the place. Beta is very much along the lines of my definition of index. Beta is the measure of achieving the risk-and-return characteristics of a given asset class. So if you've got a Beta of 1, you track the asset class exactly.

Under the Jim Wiandt definition, there are lots of different betas in the market (the beta for large-cap value and the beta for U.S. corporate bonds, for example).

Richard Kang (whom I really respect) argued in Hong Kong that "if you can wrap a quant methodology around it and have it run automatically, then it's beta." Au contraire. That is WAY, WAY out there in my view. Beta equals asset class. Period. And any way you can manage to outperform it or (more likely) hash it up is your alpha or your tracking error.

There, you see, that doesn't need to be so hard.

OK, now with my definitions in hand, let's launch into an analysis of what exactly these new funds are. Are they active funds (as Matt says) or a marketing gimmick (as Richard Ferri says in his lively comment posted onto Matt's outstanding feature).

And it is an outstanding feature, Matt, because after we debated, you really sharpened it up and covered all the angles just right. You are on that project in the article, but I know we still disagree on some of this.

First—are they active? (Or will they be when they launch?) The answer for me is an unequivocal yes. But as you know, I already think that there is a load of active on the market. Because what does active do? It goes for alpha and absolutely had significant tracking error from the bogey benchmark. And if you look at TE against the major corresponding asset class benchmarks (like the S&P 500 or Russell 1000 for large-cap U.S. stocks)—it's over 500 bps on, I don't know, 100-200 "ETFs" currently trading on the market, so to me those really are all active, even if they run on "quantitatively driven" indexes.

Clearly however, the exchange-traded product industry has shifted to something quite different from my view of active some time ago. To the (can we just say for now?) ETF industry's accepted way of thinking, active had become all about transparency, not methodology or alpha/beta. That's sort of thanks in part to the SEC, perhaps, who ran all these products through as indexes.

And frankly, I don't have a problem with any of that. We've brought increased transparency and more competitive pricing and a more tax- (and otherwise) efficient fund structure to a notoriously overpriced and inefficient investment arena. So as far as I'm concerned, these are better ways to do active if you're doing active. And there is alpha. I just dare you to find it. But—ahem—we'll leave that debate for another day.

So PowerShares Active. I DO think that the trading flexibility, any trading flexibility away from a fully transparent portfolio in real time, is a quantum leap. So I think that adding that in here is a big deal, but in the big picture actually, only an incremental step in what I've been reassured for years and years will be coming out "next quarter," which is fully active—which is active with a MUCH less transparent portfolio, with the trading value of the ETF running at a much wider real-time tracking error to the actual underlying NAV.

So does that clear it up for you?


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