Had Jerry Seinfeld pursued a career in finance, I imagine he’d be having a field day around the water cooler with the launch of the Grail American Beacon Large Cap Value ETF (GVT) yesterday: “What’s the deal with actively managed ETFs…isn’t the whole point of an ETF that is isn’t actively managed?” Since one of the primary benefits of ETFs is the reduced cost structure that they are able to offer as a result of lower asset turnover and overhead, an actively-managed ETF would appear initially to contradict itself. In reality, however, actively-managed ETFs may offer many of the same benefits as indexed ETFs while also allowing investors to attempt to beat the market.
The History of Actively-Managed ETFs and the Disclosure Dilemma
Bear Stearns Current Yield (YYY) was the first actively-managed ETF to be listed in May 2008. Shortly thereafter, ProShares introduced four actively managed funds (PQY, PQZ, PMA, and PLK) in April 2008, and another (PSR) in November. The first generation of actively-managed ETFs has faced a significant obstacle in the form of the SEC’s daily disclosure rule. Basically, whereas mutual funds are only required to disclose their holdings four times annually, actively-managed ETFs are required to do so on a daily basis. So why is this a problem? Active fund managers generally prefer not to disclose their holdings, especially when they are attempting to enter or exit a position. The fear (and reality) is that traders will know when a manager is shifting the assets of a portfolio, and will “front run” the funds position, effectively increasing prices when the manager is looking to buy and depressing prices when the manager is looking to sell. If football is a game of inches, investing is a game of basis points, and a manager’s ability to execute trades at a favorable price may be just as important as his ability to pick stocks.
Actively-Managed ETFs vs. Mutual Funds
By now, some of you may be asking “isn’t an actively-managed ETF just another way of saying ‘mutual fund’?” While there is one striking similarity between the two investment vehicles, upon further review, they’re actually more different than they may seem.
- Costs: Morningstar reports that the Grail fund will have an expense ratio of 0.79% of assets. While this is higher than indexed ETFs (which can have expense ratios as low as 0.2%), it’s still much lower than the 1.4% rate for the average mutual fund.
- Tax Efficiency: ETFs are generally more tax efficient than mutual funds due to (1) lower turnover as a result of tracking an index, and (2) the manner in which ETF shares are created and redeemed. While the benefits derived from lower asset turnover will obviously be diminished in an actively-managed fund, investors may still realize tax benefits from the ETF structure.
Actively-managed ETFs still maintain many other features of traditional indexed ETFs: no investment minimums, short-selling opportunities, more trading flexibility, and (for better or worse) more transparency.
So Where Do We Go From Here?
If actively-managed ETFs are to gain a real following, managers must find an effective way to address the disclosure requirements. PowerShares has addressed the disclosure requirements by utilizing a quantitative stock selection model and implementing a “three trade rule.” Basically, the manager of the PQZ and PQY funds uses a proprietary quantitative methodology to determine 50 stocks in which each fund will invest. The manager, however, is only able to trade three stocks each week. So these funds are far from the traditional “active management” models in which a manager has the discretion to make buy, sell, and hold decisions.
Despite the significant obstacle posed by disclosure requirements, Grail launched GVT hoping that the extended bear market has some money managers and individual investors seeking a change. In an effort to solve the disclosure dilemma, Grail has divided its ETF portfolio between three portfolio managers, so “no one portfolio manager’s portfolio will be transparent,” according to William Quinn, the chairman of American Beacon Advisors. If this strategy proves to be an effective one, don’t be surprised if the floodgates open and traditional mutual fund powerhouses battle for a share of the actively-managed ETF market.
While the future of the Grail fund is very much up in the air, one thing is for certain: all types of investment professionals, including mutual fund managers, traders, and institutional investors will be tracking its success very carefully. If it proves to be successful in attracting investors and addressing the disclosure issues, GVT could signal a huge shift in the ETF and mutual fund industries.