"I've used passive ETFs for years, but I'm an even bigger fan of active ETFs," says Chris Bertelsen, president and CIO of $2 billion Aviance Capital. His firm has used, among others, the AdvisorShares Newfleet Multi-Sector Income ETF (MINC), the First Trust Senior Loan Fund (FTSL) and the First Trust North American Energy Infrastructure Fund (EMLP). "Active ETFs allow us more flexibility and targeting in what we want to do for our clients."
Passive indexing, he says, is "subject to the tyranny of benchmarks," meaning indexed funds must hold whatever is in their indexes and in exact weights, regardless of whether those holdings are a good or bad idea. In down markets, that means index investors will hitch their wagons to underperforming or volatile stocks.
"With active management, though, you can try to make the downdraft as small as possible," Bertelsen added.
Transparency: The Existential Question
Active ETFs face significant hurdles; however, the biggest isn't an investor objection, but an issuer one.
Under current SEC rules, all ETFs must publicly disclose their complete holdings daily. (In contrast, mutual funds are only required to disclose holdings once a quarter.) This vexes active managers, who worry about telegraphing their hand to front-runners or to those who'd steal their strategies.
Transparency, however, is the secret sauce that makes the ETF vehicle work.
ETFs rely on special market makers known as "authorized participants" (APs) to maintain liquidity. APs have the purchasing power to buy up all the securities in an ETF's index and exchange them with the ETF provider for a block of ETF shares known as a "creation unit." Likewise, APs can buy up a creation unit's worth of ETF shares and redeem them for the underlying shares.
APs don't do this out of charity, of course. By harnessing minute discrepancies between the cost of a creation unit and that of an ETF's underlying securities, they can make big-league money. This arbitrage process also just so happens to keep the price of an ETF's shares in line with the cost of its underlying securities, thereby ensuring the ETF is fairly valued. Everybody wins.
So it's vitally important that APs know, at all times, exactly which securities are in an ETF and in what amounts. Without this knowledge, they won't be able to spot arbitrage opportunities. ETF prices will spiral out of whack. The whole system falls apart.