Actively Managed ETFs: Big Bang or Misfire?

Exchange-traded funds (ETFs) have enjoyed a meteoric rise in popularity over the past 15 years. Since the launch of the first ETF in 1993, institutional and retail investors alike have allocated over $796.6 billion to these funds, which passively track market indexes and trade on exchanges like stocks, and-because they trade like stocks-can be bought or sold at any time during the trading day.

Until now, ETFs have tracked a wide variety of indexes ranging from broad benchmarks to industry- and sector-specific offerings, including real estate, infrastructure, private equity, alternatively weighted and socially responsible indexes. The relationship between the index providers such as FTSE and the growing ETF market has led to innovation in both industries, driven by investor demand for increasingly specialized products. ETF assets are expected to surpass $2 trillion by 2011, and as the market grows, some industry practitioners are anxiously anticipating an evolution led by "actively managed" or "active ETFs."

The basket of stocks in an active ETF would be hand-picked by an investment manager looking to outperform, rather than passively track, a market. Concerns over transparency, SEC approval and whether or not this newest generation of ETFs will appeal to investors have been the cause of much debate amongst industry insiders over the past few years.

This debate reached fever pitch on Feb. 27, when the SEC granted four ETF providers-including Bear Stearns, PowerShares, Barclays Global Investors and WisdomTree-exemptive relief to launch the first active ETFs. The announcement has been met with much excitement by the ETF industry, but whether or not the funds will actually sell depends heavily on their transparency, liquidity and, most of all, performance.

ETF managers currently provide their ETF portfolio compositions to the market on a daily basis. Using an underlying index helps the ETF provider to provide this transparency, since indexes have clear rules that are publicly available and which govern index management in nearly all foreseeable eventualities. Thus, there are no surprises-changes are clearly communicated to investors.

Indexes are also free-float adjusted and meet liquidity screens, which in turn ensures liquidity for the index-linked ETF. Most index providers, including FTSE, have a liquidity rule which states that in order to enter and remain in an index, constituents must have a minimum percentage turnover of their free-float-adjusted shares in issue. This ensures that the basket of shares which make up an index-linked ETF includes only liquid stocks. While many investors believe that the liquidity of an ETF is dependent on the fund's average trading volume, this is not the case-the best measure of ETF liquidity is the liquidity of the underlying stocks.

Unlike index-linked ETFs, truly active ETFs may not be rules-based. Stocks may be hand-picked or chosen using a model constructed by the fund manager. Reporting may also be an issue for managers of active ETFs in less liquid markets where trades are not necessarily completed in a single day, leaving the manager open to front-runners. In order to avoid liquidity issues, managers may steer away from the smaller and niche markets that index-linked ETFs have already explored in search of alpha.

Technical aspects aside, the true measure of whether or not investors will buy active ETFs comes down to how well they perform. To begin with, active ETFs will be running without a real-world track record, and the burden of proof will be on the fund managers to create alpha and attract investors. Back-testing performance is an option, but is notoriously inaccurate. If they are able to beat the market at all, managers will have to generate a consistent record of positive performance going forward. In a down market, this will prove a challenge and will undoubtedly take some time.

While past performance is not necessarily an indication of future returns, index-linked ETFs often have years of back history showing how they have performed throughout various market cycles. The likely result will be that actively managed ETFs will be slower to gather assets and proliferate in the same way as their index-linked counterparts.

The demand for the first generation of ETFs was market-driven by investors looking to trade baskets of stocks in the same way as a single stock. Because ETFs were created to satisfy a pre-existing demand, the assets poured in. The greatest anticipators of active ETFs are their creators, who are looking to create the "next big thing." Whether or not active ETFs will prove to be the next big bang of market evolution or just a misfire is a story that only time (and fund performance) will tell.