2008 might be the year for actively managed ETFs

Another filing for actively managed ETFs was made last week, an indication that 2008 might be the year investors can finally invest in them. AdvisorShares Investments LLC, a new Bethesda, Md., company founded by Noah Hamman, a former vice president at Rydex Investments, also of Bethesda, filed last Monday to offer two actively managed equity exchange traded funds: a sector allocation ETF and a country allocation ETF. That followed a Dec. 14 filing for an actively managed equity ETF — the Grail U.S. Value Fund — from Grail Advisors LLC of New York, a subsidiary of Grail Partners LLC. PowerShares Capital Management Inc. of Wheaton Ill., a subsidiary of Invesco PLC of London, filed to offer three active equity ETFs, and one active bond ETF on Nov. 28. Although none of the filings have resulted in actively managed ETFs yet, "I do think we'll see these sooner rather," said Matt Hougan, editor of indexuniverse.com in New York. Others agree. "We're getting much closer to actively managed ETFs," said Tom Lydon, president of Global Trends Investments of Newport Beach, Calif. Each of the filings offer a solution to the problem of transparency that has frustrated the development of actively managed ETFs for years, industry experts said. The Securities and Exchange Commission insists that ETFs provide investors with transparency equivalent to stocks. That isn't a problem for an ETF that follows an index, but it can be a problem for an actively managed ETF. Active managers tend to be leery of telegraphing their moves because they wish to prevent arbitrageurs from jumping in front of trades and adversely affecting the price of a stock in which they may be interested. AdvisorShares gets around the issue by proposing an actively managed ETF that doesn't invest directly in stocks but in other ETFs, Mr. Hamman said. That solves the arbitrage issue because it is much harder for an arbitrageur to affect the price of an ETF — essentially a basket of stocks — than a single stock, he said. Grail Partners takes a different tack by essentially ignoring the issue of arbitrage. The prospectus for the Grail U.S. Value Fund says that the fund's portfolio will be "publicly disseminated each day the fund is open for business." A daily creation and redemption basket will be published as well. PowerShares takes yet another approach. Holdings in its proposed ETFs will be disclosed daily via a website for the funds, according to the PowerShares prospectus. The portfolios may only be changed on the last business day of each week. These changes will be reflected on the website prior to the opening of business on the next business day. The result is that there will always be a brief period of time in which investors won't know what the fund holds, a period in which the managers can make changes to the portfolios without having to worry about arbitrage, Mr. Hougan said. No matter what form they take, however, actively managed ETFs should give mutual funds a run for their money, said Herb Blank, president of QED International Inc. of New York, an industry consultant.

HARMING PERFORMANCE

The ETF structure is just more efficient, allowing managers to manage their portfolios without having to worry about whether market timers are proving to be a drag on fund performance, he said. They can trade in and out of an ETF all day, but because it acts like a stock and traders aren't actually buying or selling the underlying securities held by the ETF, such activity has no direct impact on the underlying portfolio. Other industry experts, however, said actively managed ETFs would be a much tougher sell than the index-based ETFs that already exist. Where index-based ETFs don't necessarily need to have a track record because investors can just look at the track record of the underlying index, actively managed ETFs will have to prove they can add value, Mr. Lydon said. As a result, assets may be slow to come, he said. David Hoffman can be reached at dhoffman@crain.com.