Legal Eagle View: Active ETFs

[This article was published in the Spring 2015 edition of ETF Report UK, our quarterly magazine for UK financial planners. To read the full issue click here]

Active ETFs may be one small step for the ETF industry, but they are a giant leap of faith for the retail investor or financial planner. Although they resemble many qualities of the traditional passive fund, like being listed on exchange, they do not track an index; rather, they rely on an active manager to cherry-pick securities to generate added value for their clients, and this often comes with higher fees. The actively managed strategy is then accessed via shares of the ETF wrapper, and can be traded intraday.

Despite a lot of hype around the subject, this particular segment of the ETF industry is still rather small. There are over 80 active ETFs in the world and they have about $15.2 (£10) billion in assets under management as of March 2014, according to data from asset manager SEI. This compares to a global total of 5,428 ETPs with $2.7 trillion assets under management, sourced from consultancy ETFGI in January 2015.

Well over half of those funds are listed in the U.S. In Europe, few providers offer active ETFs, and even fewer advisers take them into account.

ETF Report UK sat down with Monica Gogna, partner in the investment management and financial services regulation team at Ropes & Gray LLP, to discuss how active ETFs are defined and how Europe could be influenced by the major changes underway in the U.S.

ETF.com: Active ETFs have only been in existence for a few years in Europe. Would you say the concept is fully embedded and understood by investors now?

Gogna: People are still trying to get their heads around the difference between what I call a traditional, index-tracking ETF and an active ETF, versus one that uses a smart beta strategy.

At a recent industry conference on active ETFs, it was interesting to see not just the usual audience but also asset managers. I thought it was clear there are still some people who are grappling with ETFs in general, let alone active structures.

I think people are still exploring active ETFs at this stage, but I have no doubt there will be growth in this sector over time.

ETF.com: How do the European regulatory authorities define an active ETF?

Gogna: From a regulatory perspective, the European Securities and Markets Authority (ESMA) consultation paper for Undertakings for Collective Investments in Transferable Securities (UCITS) structures highlights that an actively managed ETF is defined as a UCITS fund, the manager of which has discretion over the composition of the portfolio, subject to certain policies, as opposed to a UCITS ETF, which does not have discretion.

It’s an ETF that tries to outperform the index; that’s basically it.

ETF.com: How can an investor tell the difference between an actively managed ETF and pure active funds?

Gogna: The key word is discretion. What you would have to do as an investor is assess if the manager has discretion and how that discretion is made.

You have a spectrum of ETFs – on one end is the pure passive, in the middle is the smart beta concept where you’re still tracking an index but trying also to highlight things in the index you think you can outperform, and in my view, at the other end, is the active ETF.

ETF.com: When did that ESMA paper come out?

Gogna: It was published in 2009. The guidelines have some very short provisions and additional requirements to say that it should be clearly disclosed in the prospectus and Key Investor Information Documents that the ETF is actively managed, and they should also state how the manager will meet these objectives. Everything else is the same as with a traditional passive ETF.

ETF.com: Surely the active ETF world has moved on a lot since 2009; has regulation not kept up?

Gogna: Not much has changed since 2009. This is symptomatic of the ETF industry. The guidelines were issued in 2009 but came into force on 18 Feb., 2013, then there was a transactional period for certain ETFs to comply until 18 Feb., 2014. That deadline has obviously expired now and the rules have fully kicked in.

There will be a review of UCITS products, which is ongoing, and that will include a review of ETF guidelines.

ETF.com: The Irish Stock Exchange announced in December 2014 that it no longer required issuers of active ETFs to disclose their portfolio holdings on a daily basis, to bring it in line with other exchanges in Europe. What is your take on this?

Gogna: I find that an interesting development within the ETF exchange space. But if you look at the potential developments within upcoming regulation in Europe, and the increasing focus on transparency around UCITS structures and ETFs, I think there will be another review of these kinds of details [disclosure requirements] under the Markets in Financial Instruments Directive II (MiFID II).

Transparency disclosure requirements vary from exchange to exchange in Europe, so I can’t comment on how each exchange operates in terms of active ETF issuers.

ETF.com: What stage are we at with MiFID II?

Gogna: MiFID II is coming in at the end of 2016 or the start of 2017. At the moment the MiFID II consultation paper is around 800 pages long, and was set out on 19 Dec. last year. We’re working with clients to go through what that might mean for them.

ETF.com: Currently active ETFs have generally higher annual management charges compared to traditional passive funds. Do you think costs will come down?

Gogna: I think in terms of costs, as with any industry, as it develops and there are more products in this space, there will be a reduction of costs, but by how much I can’t say.

ETF.com: The U.S. regulator, the Securities and Exchange Commission (SEC), has been analysing various new proposals for active ETFs and so-called non-transparent ETFs, to decide whether they can be brought to market. Can you expand on the changes happening there?

Gogna: In the US, any actively managed ETF has, until recently, had to be fully transparent and disclose its holdings on a T+1 [trading day plus one day] basis. Recently, the SEC has granted an exemptive relief application to asset manager Eaton Vance, permitting a type of nontransparent actively managed fund to disclose its holdings using the rules applicable to registered mutual funds as opposed to actively managed ETFs. Whilst this product is on exchange, a condition of the SEC relief is that the fund is not called an ETF and is therefore known as an ETMF [exchange-traded mutual fund] by Eaton Vance.

ETF.com: This change in the US goes against what you’ve just said about European regulators and how they’re looking to become even more transparent, not less. Do you think Europe will be influenced by the U.S. in this regard?

Gogna: In terms of trends, in this instance, I’m not convinced Europe will follow the US as it is clear that ESMA’s preference is to increase transparency requirements. It will be an interesting issue to watch as it develops.

But in general, wherever the US leads in the ETF space, eventually Europe will follow. It might not be an immediate change, but actually Europe always has one eye over the Atlantic, and we’ll learn lessons from them.

ETF.com: How do you see the ETF industry in five years’ time?

Gogna: I think there will be more regulation, and I think there will be a greater focus on transparency: it’s a theme that regulators have picked up on already