The move though attracted comments from market observers that iShares may be moving away from its roots by joining the pursuit for Active ETFs. In particular, Paul Amery of IndexUniverse Europe commented in this article that iShares may well be diluting their brand name through this move. Paul makes the point that the decision to get into actively-managed ETFs does not appear to be unanimous, with key people in the company voicing differing opinions on these products. That is likely true as even on the June 17^th, the very day iShares filed with the SEC to launch Active ETFs, BlackRock’s Global Head of ETF Research & Implementation Strategy – Deborah Fuhr – voiced her reservations on the Active ETF space taking off. Bloomberg had also reported that iShares was in talks with the SEC to launch actively-managed ETFs with reduced disclosure. The thrust of Paul’s comments was that by pursuing products such as these, iShares may be abandoning the “virtues of fund transparency” that it has become known for through its traditional passive ETFs.

Personally, I don’t think the SEC will be very amenable to the idea of reducing transparency in a product category, especially when there are live examples on the market that are already operating with full transparency. Very rarely would a regulatory body make a decision in favour of investment providers, at the expense of investors, especially given the scrutiny that they have come under of late. However, the larger debate here is that of product strategy. Is iShares really hurting its brand by going into Active ETFs? I don’t believe so.

Regardless of what the eventual transparency requirements end up being for actively-managed ETFs, they will still be more transparent than actively-managed mutual funds ever have been. So if you look at the alternatives where investors could access active management, I think investors would be much better off taking advantage of the tax efficiency, daily liquidity, lower costs and yes, the greater transparency, of Active ETFs compared to actively-managed mutual funds. I see iShares’ move into this space as extending benefits that the ETF structure brings as a whole, to a wider range of investors. The difference is that now those same benefits that passive investors have enjoyed through ETFs in the last decade can be extended to investors who are looking for active management. Product innovation that will help iShares build its presence in the US Active ETF space will not compromise its current brand positioning, but will more likely serve to extend its market leadership.

More recently, BlackRock iShares made another move and filed for a 130/30 long-short strategy that will be passively-managed but the underlying index will be based on a quantitative model. Bloomberg quoted a BlackRock spokeswoman, Christine Hudacko, who said that, “We may offer long-short strategies in any number of ways, one being we would track an index. We may also do it in other ways, such as more active-type strategies”. That just reinforces the idea that iShares is looking to push the capabilities of the ETF structure and bring make more dynamic strategies accessible to the common investor through a vehicle that they have easy access to. Yes, they could end up being less transparent than traditional index ETFs in the unlikely scenario that the SEC agrees to products with reduced disclosure, but even then the proposed ETFs would still be better off than actively-managed mutual funds.
 
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Reported by Bloomberg, BlackRock iShares – by far the largest issuer of ETFs in the world – is now seeking approval from the SEC for actively-managed ETFs “that would keep some of their assets undisclosed”. If such a modification to the Active ETF structure gets approved by the SEC, many issuers and managers would be much more comfortable in bringing strong active managers to the Active ETF space without fear for their strategies being front-run. In more than 2 years of existence, the Active ETF space has not seen the arrival of big name active managers operating funds within the ETF wrapper. Only very recently has there been some promise of that changing, with Grail Advisors forming a partnership with DoubleLine which is lead by the illustrious Jeffery Gundlach, a fixed-income manager who is spoken of in the same company as Bill Gross. However, even then, the actively-managed emerging market bond ETF that Grail and DoubleLine have filed for does not have Jeffery Gundlach’s name behind it. Given that emerging market bond strategy is the only one within DoubleLine that is not currently lead by Jeffery Gundlach provides the hint that even DoubleLine wants to evaluate the success of their first product before putting its star manager behind a new Active ETF. If the modification in structure proposed by iShares comes to pass, that would definitely go a long way towards providing confidence to star managers that their investment know-how and trading strategies will not be “given away” at the end of each day.

SEC’s Concern

The head of SEC’s investment-management arm, Andrew Donohue, mentioned in the Bloomberg piece that he was primarily concerned about disrupting the process that “keeps a fund’s per-share net asset value and share price closely aligned”. This is a genuine concern because if fund disclosure was to happen less frequently, then the market maker who has the responsibility of arbitraging to keep the ETF price close to NAV will have difficulty in doing that effectively. Without knowledge of what the fund’s holdings were on the previous day, the creation/redemption process – the means by which the arbitrage process occurs – will likely be hampered as the market maker would be operating with a stale view of the fund’s composition.

Learning From Neighbours?

As was proposed in this article, a good idea might be to pick up a few regulatory insights from other countries and how they regulate actively-managed ETFs. In Canada, Active ETFs are not required to provide daily disclosure of holdings. In fact, the leading provider of these products in Canada, Horizons AlphaPro, discloses holdings only once a month, which is still better than most mutual funds. However, they provide complete disclosure of the fund to the ETF’s market makers so that they have all the information they need to make markets and minimize the discount/premium of the ETF share price from NAV. So that’s a framework worth considering by the SEC – providing complete but confidential disclosure of the fund holdings to the market maker or AP on a daily basis while providing public disclosure with a lower frequency in order to safeguard the manager’s value proposition.

Fundamental Difference

Looking at the bigger picture, there is a fundamental difference in how actively-managed ETFs have been evaluated by regulatory bodies in the US versus those in Canada that has resulted in the policy requirements for each. In the US, Active ETFs have been seen as “ETFs” first and actively-managed funds second. Hence, the US requirement to provide daily disclosure of holdings as is the norm for all other ETFs. In Canada, they are considered first to be actively-managed funds and are thus regulated in much the same way that active mutual funds are regulated in Canada.

How this debate plays out will be very interesting to see and the approach that the SEC takes to regulate actively-managed ETFs in the US will likely have huge ramifications on the attractiveness of these products to issuers and renowned active managers. BlackRock iShares, being the biggest ETF issuer, has already lead the way in bringing up the issue with the SEC. If the SEC decides to address these concerns, it could be a big win for the Active ETF issuers.
 
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However, with this filing, iShares has indeed announced its intentions and the writing on the wall is becoming clearer by the day. When Legg Mason filed to launch these products in February, 2010, it was seen as a possible turning point for the industry, with Legg Mason being one of the largest asset managers having $679 billion in assets under management. This was followed by Eaton Vance joining the line to launch Active ETFs in March, 2010 and provided support for the view that major mutual fund players were using this opportunity to enter the ETF market – a market they had seen growing exponentially in the last 4-5 years.

Now, with iShares’ latest filing, the top 4 ETF providers in the United States who make up close to 90% of all US assets within ETFs – iShares, State Street Global Advisors, Vanguard and PowerShares – each either already have actively-managed ETFs on the market, or have filed to launch products to join the Active ETF space. And the fact that iShares itself holds more than 50% of all US ETF assets and more than 46% of all global ETF assets makes their entrance into the actively-managed space all the more significant. iShares, now being part of BlackRock, also has the advantage of being associated with a well-reputed and established active manager that can provide the expertise and managers needed to launch actively-managed products.

What’s most indicative of the growth the Active ETF space is likely to see is the ratio of existing Active ETF providers to prospective issuers who are filed to launch Active ETFs. While there are only 6 issuers with actively-managed ETFs on the market currently, iShares’ filing brings the number of new companies who have filed to launch these products closer to 20. That fact alone means that the Active ETF space will not be seeing any shortage of activity for the next few years.

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BlackRock iShares already has an existing actively-managed ETF which is the iShares Diversified Alternatives Trust (ALT: 50.15 0.00%) which is the only Active ETF on the market to follow a hedge fund like strategy. The new filing plans is quite general as was the Dreyfus filing earlier this week, but it does provide a preview of two new ETFs that are in the works. Given how generic the current strategies are, both funds are likely to become more refined and have a more focused strategy that would be revealed closer to their launch. Both funds will be advised by BlackRock Fund Advisors. :

1. iShares Active Fixed Income Fund – The objective of this fund will be to provide a combination of income and capital growth and it will use quantitative models to allocate assets amongst various sectors. Interestingly, the filing indicates that this fund will get its exposure by investing 80% of its assets in other ETFs advised by BFA that in turn invest in the fixed-income markets. So it appears that this initial fund will be looking to invest through other ETFs.

2. iShares Active Equity Fund – This fund will look to provide long-term capital appreciation and will invest in domestic large caps in general, based on the relative return potential of the securities.

The other issuer that filed for actively-managed ETFs was Huntington Asset Advisors which has been managing money since 1917 and currently has $13 billion in assets under management . The advisor is a subsidiary of The Huntington National Bank. Huntington has filed to get relief for two quite interesting funds that are detailed in its prospectus:

1. Global Rotating Strategy Fund – This fund will looks to achieve capital appreciation by investing in equities from different market segments such as small-cap, large cap, global equity, on the basis of current economic conditions and which segment is the most attractive give those conditions. The only sector rotation fund in the Active ETF space currently is in Canada, the Horizons AlphaPro Seasonal Rotation Fund (HAC).

2. EcoLogical Strategy Fund – This fund also tries to achieve capital appreciation by investing in domestic stocks that satisfy one or more environmental themes. The fund can invest in companies of varying market cap and even those in foreign markets. This fund would be the first “green” oriented actively-managed ETF, if it comes to market.

 
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Links: Website, Factsheet, Prospectus

Investment Strategy:

(ALT: 50.15 0.00%) invests in a combination of foreign currency forwards and exchange-traded futures on commodities, currencies, interest rates, equity and bond indices in order to achieve the maximum absolute return for the portfolio. The fund reduces risks by taking long/short positions in “historically correlated” assets. There are no mandatory allocation requirements between the various asset classes. The portfolio targets an annual volatility of 6-8% and a Sharpe ratio of 0.50-0.75. The specific strategies utilized by ALT include:

1.  “Yield and Futures Curve Arbitrage Strategies” – which profit from interest rate and futures contract price differentials.

2. “Technical Strategies” – which explore relationships between an assets’ historical return and its recent performance and then use quantitative models take up long/short positions. These are also called momentum or reversal strategies.

3. “Fundamental Relative Value Strategies” – which exploits discrepancies between an assets’ fundamental value and its market price.

Portfolio Managers:

Barclays Global Fund Advisors serves as the advisors for the trust. Ryan Braniff, supervised by Alan Mason, is primarily responsible for making the investment decisions for ALT.

Alan Mason, Principal – Mr. Mason is responsible for multi-asset class solutions at Barclays Global Investors (BGI) and has been with BGI since 1991.

Ryan Braniff, Principal – Mr. Braniff has led a team of portfolio managers at BGI that manage multi-asset class portfolios and has been with BGI since 2005.

The Numbers:

Expense Ratio –0.95%

Average Volume – n/a

Average bid-ask ratio: n/a

What’s special about it?

1. ALT is the only actively-managed ETF on the market that provides access to the commodities and futures market to retail investors, which has been a space largely dominated by institutional investors so far.

2. The trust doesn’t expect trading to occur more than once a week, although the advisors do have the authority to trade more frequently if necessary.

3. ALT is allowed to invest in futures listed on foreign as well as US exchanges while it may enter into foreign currency forwards primarily involving the 25 most actively-traded currencies.

Analysis:

Positives –

- ALT looks to maintain an absolute return profile, which means that it should not be affected as much by directional influences of the market. So even if the market is tanking, ALT should experience lower volatility because it takes long/short positions instead of making one sided bets.

- ALT controls its net credit exposure to counterparties by not allowing the maximum exposure to one single entity to exceed 10% of the portfolio’s NAV. This should guard it against a Lehman type scenario.

Negatives –

- ALT claims to reduce risk by taking long/short positions in “historically correlated” assets, but the one thing we’ve learnt from the past crisis is that in times of stress, all “normal” correlations break down, so don’t count on old correlations holding up to reduce risk effectively.

- At 0.95%, the hefty expense ratio is the 2^nd highest in the US Active ETF space, after the Dent Tactical ETF. However, being the only player to venture outside of equities and fixed income means that any investors looking for exposure to other asset classes only have ALT as an option.

- In general, the strategies utilized by the investment team, are likely too complex for retail investors to grasp which might result in un-sophisticated investors staying away from ALT.

Performance since inception vs. iShares S&P GSCI Commodity-Indexed Trust:

Disclosure: No position in above-mentioned names.
 
Disclaimer: Views and opinions expressed on EtfsHub are those of the author alone and do not in any way represent the official views, positions or opinions of the employers – both past or present – of the author in question, or any other institutions and corporations associated with the author. Neither the information nor any opinions contained or expressed above and elsewhere on EtfsHub constitutes or should be construed as a solicitation or offer by EtfsHub to buy or sell any securities or other financial instruments or to provide any investment advice or recommendations. EtfsHub shall not be liable for any claims or losses of any nature, arising indirectly or directly from use of the information on or accessed through the site. Please see full disclaimers here.