The active ETF space has gained momentum in recent months. For starters, in early December 2012, the SEC finally ruled that active ETFs would be permitted to hold derivatives in their portfolios.
Since this ruling, we’ve had a number of fund firms asking for permission to offer active ETFs with derivatives, including Hancock, Fidelity and Emerging Global. In addition, companies like Schwab and State Street have been putting an increasing number of active funds into actual registration.
However, long before this ruling, changes to the active-ETF landscape have been brewing.
Since 2011, firms from Eaton Vance to BlackRock filed with the SEC for nontransparent active ETFs, which would enable the managers to disclose the funds’ holdings on a quarterly basis, as opposed to the current daily disclosure requirement for active funds. No one has received the green light yet from regulators.
Then late last month, Precidian Funds became the latest issuer to file for nontransparent active ETFs, proposing a yet-to-be-approved method, like that of BlackRock’s, that would use a blind trust to guard the active manager’s secret sauce.
But with respect to existing active ETFs, I think the launch of the Pimco Total Return ETF (NYSEArca: BOND) in March 2012 is perhaps one of the most significant milestones in the active ETF space.
Just to put into context how successful BOND has been, within the $11.6 billion in total assets in active ETFs—which constitutes only 0.80 percent of the $1.43 trillion in total U.S. ETF assets—BOND’s $4 billion in assets already constitutes more than a third of that amount.
While BOND’s success comes as no surprise considering Bill Gross’s star power, I think what makes BOND so special is its ability to go anywhere in the world, own any type of fixed-income product on any part of the yield curve—a byproduct of its active management structure.
In fact, total assets in active ETFs are overwhelmingly parked in fixed-income products.
Data as of 1/31/13
The issue with many traditional market-value-weighted fixed-income ETFs like the $18 billion Vanguard Total Bond Market ETF (NYSEArca: BND) and the $14.9 billion iShares Core Total US Bond Market ETF (NYSEArca: AGG) is that by design, they overweight securities with the most debt issuance by market value, which basically means Treasurys.
Now, I don’t know of many investors wanting to be overweight Treasurys right now—especially longer-duration bonds—with 10-year yields still below 2 percent and rising since last summer.
But I also think that BOND may have started a new dawn in the ETF world, one in which fund managers begin launching ETF versions of their flagship mutual funds, as ETFs pull more assets away from traditional mutual funds.
Only a few weeks after the launch of BOND, we saw a filing by currency guru Axel Merk to launch an ETF version of his flagship Merk Hard Currency Fund (MERKX), which he plans to call the Merk Hard Currency ETF, and plans to give it the ticker “MERK.”
What’s truly striking is the lack of assets in active equity ETFs—currently only $512 million. That amounts to only 0.05 percent of all equity ETFs assets. One reason for the lack of assets might be because the equity front has yet to make a splash with a famous mutual fund manager, the way Bill Gross launched BOND in the fixed-income space.
Still, I can certainly see some segments within equity that would make sense for active management. I think the emerging and frontier markets space is one such area.
The issue with traditional cap-weighted emerging and frontier markets indexes is that by design, they’re top heavy in many of the same state-owned enterprises—usually from the energy, financial or telecom sectors—that tend to dominate a large swath of a country’s entire market cap.
Moreover, index-based emerging and frontier funds are bound by the country classifications of the index they’re tracking. This means for MSCI-based emerging indexes, it includes South Korea and Taiwan, and carries heavy exposure to the BRICs.
Ruchir Sharma, head of emerging markets at Morgan Stanley, has been saying now for years that the concerted growth within all emerging economies that we saw in the early part of the century may be drawing to a close—or may actually be over, for that matter—and that it’s increasingly making sense to become selective in the emerging landscape.
In a recent interview with IndexUniverse, Jim O’Neill, the “godfather” of the BRICs, agreed, stating that it no longer makes sense to treat all emerging markets as one giant market.
The case for active may be even stronger in the frontier space, where the line between emerging and frontier classification is increasingly becoming muddled, and the dislocations between the development levels between frontier countries is even more extreme.
For example, Qatar and UAE are on the verge of being upgraded to emerging status by MSCI. Should those two countries really be in the same classification with countries like Sri Lanka or Romania?
These dislocations mean for indexes trying to target the frontier space—like the MSCI Frontier Markets Index—that it’s overwhelmingly tilted toward the Middle East.
Taking all this into account, I think Emerging Global Advisors is on to something with the market’s first filing for an actively managed emerging markets ETF. With active management, not only can the manager be selective with specific companies, it’s no longer bound by country classifications based on index providers.
As I mentioned in a previous blog, I think actively managed equity ETFs will eventually blossom when big-time equity managers start launching ETF versions of their flagship mutual funds (like if Mark Mobius decided to launch an ETF version of his Templeton Frontier Markets Fund).
It's inevitable that as assets pour into ETFs, the landscape will continue to evolve. I think active ETFs are only one aspect of the growing industry where we’ll see change.
In fact, the changing active ETF landscape may already be brewing right underneath us.
At the time this article was written, the author held a long position in BOND. Contact Dennis Hudachek at [email protected]
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