In Search Of An Active ETF Model

January 16, 2014

Despite growing interest, there’s no standard model for exchange-traded funds that aim to outperform


[This article originally appeared on our sister site,]

Most exchange-traded funds (ETFs) are rules-based, aiming to track an index. But many fund operators are now looking to marry discretionary active management with an exchange listing, seeking to capitalise on the ETF boom.

In the US, the securities market regulator has so far permitted so-called “active ETFs” to be launched only under a stringent condition—the daily disclosure of portfolio holdings. This has prevented many active fund managers, who regard such information as market-sensitive, from seeking to launch ETF versions of their strategies. While most index-based ETFs in the US also show their holdings daily, legally they are only required to do so each quarter.

Now, however, the SEC faces a lengthening backlog of requests to approve non-transparent active exchange-traded funds (ETFs), which would reveal their holdings less frequently and with a lag. If such applications are given the green light, a flood of exchange listings by the leading active fund issuers could follow.

In Europe, where mutual funds have been traded on stock exchanges since the 19th century, both transparent and non-transparent active ETFs already exist. By contrast with the US, EU regulators set no specific disclosure requirements for this type of fund.

Non-EU Switzerland does not currently permit ETFs that are based on discretionary management strategies, though this may soon change, according to market contacts.

Confusingly, this side of the Atlantic there’s also a significant number of actively managed funds that are not called ETFs but which resemble them by being exchange-traded. Such funds are bought and sold by investors on the region’s stock exchanges as an alternative to dealing directly with the fund issuer or with intermediaries such as financial advisers or fund platforms.

Around 3000 active mutual funds are traded in real time on Frankfurt’s XETRA market, for example, over double the number of ETFs listed on the exchange.

Trading funds on-exchange not only offers investors immediate knowledge of the execution price, but can also promise cost advantages: although investors face a spread between market makers’ bid and offer prices for fund units, they may be able to avoid paying a front-end load (initial charge) to the fund issuer by using the exchange for their purchase.

Surprisingly, given the growing popularity of the ETF label, some of those connected with the listed mutual funds business don’t want to be associated with it. When Europe’s securities regulator, ESMA, issued consultations about ETFs in 2011 and 2012 with a view to bringing in new regulations, the Danish Fund Association made it clear that it viewed its stock exchange’s traded fund segment as distinct from ETFs.

The mechanisms for European exchanges’ non-ETF fund trading segments vary. Some resemble the traditional mutual fund model of settling deals on a forward pricing basis, taking orders by a regular cut-off point and informing investors later of the price at which deals have been struck.


NYSE Euronext, for example, operates a net asset value (NAV) trading facility for around 230 non-ETF active funds on its Dutch stock exchange, using the standard mutual fund forward pricing model.

On other European exchanges, fund trading resembles the ETF model of continuous intraday pricing. ESMA, in its 2012 guidelines, specified that all EU-based ETFs, including active ones, must have at least one market maker to ensure that a fund’s secondary market price does not vary significantly from its fair value.

Germany’s stock exchange, together with Switzerland’s SIX exchange and Denmark’s Nasdaq OMX exchange all operate versions of this trading model, with market makers offering to buy and sell fund units on the basis of a fund’s real-time value.

These differences in market practice, both within Europe and globally, could lead to confusion, admits Deborah Fuhr, partner at consultancy ETFGI.

“Many of Europe’s exchanges are creating mechanisms for the listing and trading of open-ended mutual funds, but usually these aren’t called ETFs,” said Fuhr.

“There’s potential for confusion: we could have a fund listed in the US and called an active ETF, while in Europe something very similar is not,” she said.

For those considering an active ETF launch, meeting the minimum regulatory requirements for tradeability does not ensure a fund’s success, says Europe’s leading issuer of this type of structure.

Over half the inflows into the funds of London-based ETF issuer Source during the last two years have been into what the firm calls value-added strategies.

“The word ‘ETF’ is just a wrapper,” M.J. Lytle, Source’s chief development officer, told

“There are two things to ask if you’re considering converting an active fund into an ETF: can you trade it, and can you trade it well? To trade it, you need a single market maker and to disclose a certain amount of information on a daily basis. To trade it well, you need to get the whole market involved, with multiple market makers and a real depth of liquidity. Even amongst index-tracking ETFs, only a few have those characteristics,” said Lytle.

Many of the active managers who approach Source with a view to creating ETF versions of their fund strategies end up deciding they are not comfortable with meeting the levels of disclosure that ETFs typically provide as a matter of course, said Lytle.

Some managers emphasise the potential cost savings that active ETFs can offer over traditional fund structures.

When making its recent application for a non-transparent active ETF in the US, fund manager Eaton Vance claimed its approach could improve returns by 50 basis points a year over those of a traditional mutual fund by economising on operating expenses and trading costs.


Fund manager Swiss and Global, which has listed four active equity ETFs on the German Stock Exchange, says its ETFs’ annual charges of 60-70 basis points are less than half those of its in-house mutual funds that follow equivalent strategies.

“Clients are looking for cost-efficient structures that are transparent and liquid,” Swiss and Global’s head of product, Dirk Kubisch, told “Active ETFs are a growth area and we expect to see high demand down the road.”

An exchange listing may benefit fund issuers, given the ongoing reforms of the region’s rules for financial product distribution, says the head of exchange-traded products at one of Europe’s major trading venues.

“The Netherlands is in the process of introducing its version of the UK’s Retail Distribution Review, under which inducements to fund distributors were banned, and issuers are looking for more efficient ways to distribute funds. Our NAV trading facility seems a perfect fit for many of them,” NYSE Euronext’s Pedro Fernandes told

The active ETF concept still has sceptics, particularly if funds offer only limited transparency.

“The fundamental challenge is how to conduct an effective active strategy without disclosing how you do it,” Feargal Dempsey, an independent ETF consultant and formerly head of product strategy for iShares in Europe, told

“If you only offer full disclosure after the fact, while some market participants are aware of changes before others, that raises concerns about the release of market-sensitive information, even if you put safeguards like Chinese walls in place. And do you really need an ETF wrapper around every active strategy? So-called smart beta or alternative index strategies are a more logical progression from traditional ETFs than truly active funds in an ETF wrapper,” said Dempsey.

Nevertheless, the signs are that we will see more and more active ETF launches, particularly if US regulators ease the rules.

“Whether or not to use the term ETF for a discretionary fund comes down primarily to marketing and brand strategy, since the disclosure rules for any European UCITS fund, whether the fund is an ETF or not, are essentially the same,” Monica Gogna, partner at law firm Pinsent Masons, told

“If active ETFs take off in the US fund market it’s likely we’ll see a similar trend in Europe,” said Gogna.

NYSE Euronext’s ETP head agrees.

“It will be a natural progression for ETFs to move from traditional, market-weighted indices, to smart beta and then to active ETFs,” Pedro Fernandes told

“But promoters of active ETFs need to respond to the key features of traditional ETFs: intraday liquidity and price transparency. As long as market-makers are informed of the make-up of the ETF basket, allowing them to create an efficient market, I don’t see why this product can’t be successful.”



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