Is income distribution the next ETF frontier?

Hoping to address the income needs of retiring baby boomers, providers of exchange-traded funds are gearing up to introduce new income-oriented products. Fixed-income ETFs already pay out monthly or quarterly dividends, but the industry is looking beyond such products, industry executives said during a round-table discussion held Nov. 4 at InvestmentNews' New York offices. “You may see some type of a managed distribution or an income stream that flows through [to the investor] so the investor does not have to sell units of the ETF,” said Christian Magoon, president and senior managing director of Claymore Securities Inc. and Claymore Advisors LLC. Acknowledging that a drawback of ETFs is the need to sell part of the holdings to create an income stream, James Ross, senior managing director at State Street Global Advisors, said he expects to see new products that address that. The development of actively managed ETFs remains problematic, the panelists agreed.

'A cop-out'

Mr. Ross noted that the SEC's requirement that ETFs provide full transparency flies in the face of the active managers' insistence on concealing their moves from market timers. “You can't have an active mutual fund you'd have today that's research-driven and fundamental, and tell that portfolio manager you're going to disclose his holdings on a daily basis for everyone to see,” he said. “It's just not going to be well-received.” Edward McRedmond, senior vice president and director of institutional and portfolio strategies at Invesco PowerShares Capital Management LLC, disagreed. “I think it's somewhat of a cop-out, because the reality is, if you're a separate-account manager ... you're disclosing your holdings on a daily basis,” he said. Invesco PowerShares launched the first equity-oriented actively managed ETFs in April 2008. Such funds have yet to catch on with investors — the firm's five actively managed ETFs have just over $29 million in combined assets — but Mr. McRedmond believes it's just a matter of time. That's because ETFs, unlike mutual funds, allow investors to pay most capital gains taxes on final sale of the ETF. That means money that would have gone to taxes initially is allowed to accumulate as wealth. “If you can capture back a big part of what's lost through the mutual fund delivery vehicle, that in and of itself should be a huge value for delivering active management through the ETF structure,” Mr. McRedmond said. Even if that's true, however, before actively managed ETFs can gain traction, they will have to prove they can add value, something that can take many years, said Martha G. Papariello, a principal and head of the financial adviser services unit at The Vanguard Group Inc. “We'll have to be patient and maybe give it three, four or five years to see what the real end story is with true active ETFs,” she said. There can be problems, however, with any product. It's something the ETF industry learned this year with regard to leveraged and inverse ETFs, and exchange-traded products that invest in commodities futures. Problems for leveraged and inverse ETFs began in June when the Financial Industry Regulatory Authority Inc. warned brokers that such products “typically are unsuitable for retail investors” who hold them longer than than one day. Finra clarified its position on such ETFs in a podcast July 13 in which it said member firms could recommend that a retail investor hold them for longer than that, provided a suitability assessment is conducted with respect to such an investor and the ETF. But by then, the damage was done. Providers of leveraged and inverse ETFs face several lawsuits concerning the sale of such products, and some brokerage firms have placed restrictions on their sale. To a large extent, the problems for leveraged and inverse ETFs were the result of investors' “misunderstanding” the way such ETFs work, said Noel Archard, managing director and head of product research and development at iShares. Investors have become better-educated, however, and as a result, leveraged and inverse ETFs won't likely attract as much negative attention in 2010, he said. The same can be said of exchange-traded commodities funds. The Commodity Futures Trading Commission has been investigating concerns over excessive speculation in futures markets as epitomized by the run-up in oil prices last year and in 2007 — speculation that it thinks exchange-traded products may have helped facilitate. As a result, it revoked relief it had granted DB Commodity Services LLC, a unit of Deutsche Bank AG, permitting its exchange-traded commodities funds — which are so similar to ETFs that they are often referred to as such — to exceed federal speculative position limits in corn, soybeans and wheat futures. The funds are managed by DB Commodity Services and marketed by Invesco PowerShares. Mr. Archard said he doesn't believe that the CFTC will be going after many more such products. “I don't think we're going to see a lot more of this,” he said. That may be true, but the industry isn't going to take any chances. In addition to product launches, it will step up its efforts to educate investors in 2010, said Carl Resnick, a managing director and portfolio strategist at Rydex SGI. “You have to know what you own,” he said. E-mail David Hoffman at dhoffman@investmentnews.com.