Bringing to market actively managed exchange traded funds has proved to be an elusive goal, but at least six managers think that they have the secret formula to make these vehicles work.
The managers either have filed registration statements with the Securities and Exchange Commission or filed for regulatory relief to do what hasn't previously been done.
The Vanguard Group Inc. of Malvern, Pa., and Bear Stearns Asset Management Inc. of New York each have filed proposals for actively managed ETFs.
Firsthand Capital Management Inc. of San Jose, Calif., Managed ETFs LLC of Summit, N.J., AER Advisors Inc. of North Hampton, N.H., and XShares Advisors LLC of New York have filed for exemptive relief to offer such funds.
U.S. investors have poured more than $500 billion into passively managed ETFs — investment vehicles that track an index but trade on an exchange.
Passive ETFs are seen as a more efficient and lower-cost alternative to index mutual funds.
Managers who are looking to launch actively managed ETFs want to keep those benefits while outperforming the market.
But managers who are trying to launch the next wave of ETFs have come up against regulatory hurdles, the stickiest of which involves transparency. Managers worry that full transparency of their trades will betray their investment processes and open the door for front-runners.
For some managers, the answer is to have lag time between when a transaction is executed and when it is reported, while others think that they can manage daily reports; passive ETF managers report holdings daily.
The SEC wants transparency, said Phil Mosakowski, marketing consultant at Firsthand Capital.
However, he asked, how can a manager protect shareholders and the fund's investment process if the securities that the manager is buying and selling are completely transparent?
Firsthand Capital filed for ex-emptive relief with the SEC in December 2004. Officials at the firm plan to use a quantitative approach to select technology stocks from the Standard & Poor's 500 stock index, Mr. Mosakowski said.
The firm intends to report its holdings on a daily basis and complete trades in a single day in order to avoid front-running problems.
The approach is possible with large, liquid stocks such as those in the S&P 500, but it could be a problem in markets with less liquidity, Mr. Mosakowski said.
Vanguard and Bear Stearns have the most-developed strategies so far, and each is sticking to the fixed-income markets.
Vanguard filed a prospectus to create new ETF share classes of its established short-term, intermediate-term and long-term Treasury funds. It proposes to offer a sample of its holdings once a day, as is done with passive ETFs, according to its SEC filing.
The firm would develop a basket of about 20 securities with similar characteristics such as maturity, credit quality or yield. The sample would duplicate between 50% and 75% of the actual fund holdings, allowing arbitrageurs to capture any premium or discount that occurs as a result of changes in the net asset value of the shares, according to the registration.
Vanguard officials weren't available to comment.
Bear Stearns Asset Management filed a prospectus in March to establish an actively managed fund called the YYY Trust. The trust, if approved, will invest in money market and short-term fixed-income investments, according to the filing.
Jane Slater, a spokeswoman at Bear Stearns, declined to comment, citing the fund's registration period.
It is no coincidence that both firms have filed for fixed-income funds, said Sonya Morris, a fund analyst and editor of Morningstar ETFInvestor, a monthly newsletter issued by Morningstar Inc. of Chicago.
"ETFs ... have to reveal their holdings every day, so that has far more consequence for an equity manager," she said.
Front-runners aren't likely to have an effect on Bear Stearns' short-term-bond trades or Vanguard's "plain vanilla" investment style, Mr. Morris said.
"Bear Stearns' filing is limited in scope and will work within the limited context it is designed to work," said Gary Gastineau, co-founder of Managed ETFs and former senior vice president of product development at the American Stock Ex-change. "It is not a full-fledged answer to the active question."
Mr. Gastineau said his firm has been negotiating with the SEC about its request for regulatory relief since August 2005, but he was tight-lipped about the firm's potential offering.
Officials at Managed ETFs think that by using their proprietary model, they can replicate any strategy a mutual fund offers, he said.
Mr. Gastineau thinks that his firm has solved the problem of transparency, though he declined to say how.
"If things work out, we'll go public [with the solution in] between three to six months," he said. Mr. Gastineau thinks that for most active ETFs, following a reporting model similar to that of mutual funds — reporting once a quarter, with a 60-day lag, for example — will be adequate.
His views put him in line with other managers who think that the delay in reporting will protect the manager's "secret sauce" and shareholder interests.
Officials at XShares also think that offering a lag time is the simplest answer, said the company's chairman, Jeffrey Feldman.
But other solutions exist, such as Vanguard's sampling technique, he said.
XShares hasn't developed the nuts and bolts of its potential offering yet.
"This is a bootstrap operation. We have to know what [the SEC] will allow us to do first," Mr. Feldman said.
The firm's active ETFs likely will include equities, fixed income and other asset classes.
And while XShares' existing ETFs are quantitative, active ETFs open the door to adding some subjectivity into the equation, Mr. Feldman said.
Barclays Global Investors of San Francisco is the largest passive-ETF provider, and officials there have been vocal about plans eventually to move into the active arena.
With more than $285 billion in its iShares products as of Aug. 31, BGI holds more than 50% of the ETF market share in the United States, according to data compiled by State Street Global Advisors of Boston.
"It's a natural direction," said Noel Archard, head of U.S. iShares product development. "There's been the thought for years that if this is happening for passive, why not active?"
But Barclays officials are struggling with developing an active product that can outperform year after year while still maintaining the benefits of passive ETFs, Mr. Archard said.
"It's still a wide-open ballpark," he said regarding asset classes that could be a good fit for active management.
"The temptation is to jump into something esoteric like 120/20 [long/short portfolios]. While those products are interesting, we wouldn't want to ignore the core asset classes." Mr. Archard said.
He declined to provide a timeline for a possible launch.
David O'Leary, chief executive at AER Advisors, declined to comment.
The verdict on whether these new products will make a dent in the ETF market is still out.
"I'm not sure that we know what the demand will be," Mr. Feldman said. "It's too new."
