Active ETF Update

By IndexUniverse Staff - Wednesday, 13 June 2007

Ian Salisbury of Dow Jones provides the latest update on active ETFs in today’s Wall Street Journal. Salisbury profiles the early SEC filings of two members of the active ETF vanguard—AER Advisors and XShares Advisors—both of whom have filed exemptive relief requests to launch active ETFs. Exemptive relief is a stage before a fund company files a prospectus, when they ask the SEC to adjust certain rules to allow their funds to list. The specific filings are not available online—they’re only available as paper filings—but Salisbury gives the gist. “Both companies made filings on their proposals in May and emphasize that they differ only slightly from existing funds, which may make them palatable to the SEC,” writes Salisbury. The big issue with actively managed ETFs is front-running. We’re told that active managers are loath to disclose their holdings for fear that others will either mimic them or, worse, jump in front of them purchases and drive up the prices of the underlying stocks (“front-running”). That’s a problem because ETFs must disclose their holdings to allow arbitrageurs to keep the ETF share price in-line with the underlying components. That arbitrage ability is what separates ETFs from closed-end funds. To get around this problem, AER will impose restrictions on its fund managers: they can only make changes to their portfolios once a week, and they must announce those changes on Friday and implement them the following Monday. Apparently, AER thinks this will limit the impact of front-running, although it seems unlikely to eliminate it entirely (assuming that front-running really exists). The XShares proposal, in contrast, would allow managers to make changes intraday … but would only announce those changes at day-end, after the markets’ closed. That might complicate the work of arbs and lead to bigger bid/ask spreads on the ETF, but it would generally work and would avoid the front-running problem for all but the largest trades. Other active ETF filings, not covered in the Wall Street Journal article, would create proxy portfolios that reflect the value of the underlying ETF but with different components. Of course, all of these proposals beg an important question: Why do we want active ETFs in the first place? The track record of actively managed mutual funds is poor, with the vast majority trailing index funds over the long haul. The fact that the majority of investors choose these funds says that there is demand, and ETFs would deliver those returns in a slightly cheaper, slightly more tax efficient package. But the issue of long-term performance will remain.