Asks for comment about regulations

Actively managed exchange-traded funds, which would compete directly with mutual funds, are moving closer to fruition.

The Securities and Exchange Commission issued a “concept release” earlier this month, asking for comments about how to regulate actively managed ETFs.

If approved, the ETFs would offer advisers and their clients a more flexible investment tool.

So far, the only ETFs that have been traded in the United States have been index-based funds.

ETFs are mutual funds that trade like stocks on exchanges, changing price throughout the day. They increasingly are seen as competitors to standard mutual funds.

Index-based ETFs have become popular because of their low costs and tax efficiency.

Sales of ETFs this year are expected to be just under $42 billion, slightly down from last year’s volume but up from only $6.4 billion in 1998.

The number of index-based ETFs had grown to 78 by the end of 2000, up from 30 at the end of 1999. Assets held in the funds had increased 86% to nearly $63 billion, from less than $34 billion over the same time.

As it studies the comments – which will be accepted until mid-January from the industry and the public – the SEC will explore setting up a pilot program to trade actively managed ETFs.

Transparency

The release, which had been expected for some time, details the agency’s concerns.

A chief issue to be addressed is how investors and market makers would price the funds, since fund managers could change their investments during the trading day, says David Smith, associate director of the SEC’s division of investment management.

“We’re interested both in the operational aspects of an exchange-traded fund – how it’s run day to day, including transparency,” says Mr. Smith.

In addition, he says, the SEC wants to examine “how investors of all types – retail and institutional – would use an actively managed product.”

So far two companies have applied to offer actively managed ETFs to the public: Rydex Funds of Rockville, Md., and ProFunds of nearby Bethesda, Md., Mr. Smith says.

Rydex would not comment on the issue, and Michael Sapir, chairman of ProFunds, was unavailable to comment.

Both companies are noted for their sector funds and offerings targeting market timers.

While investors in index-based ETFs have bought them largely for their low cost and tax efficiency, actively managed ETFs may not have those same benefits, says Gavin Quill, senior vice president at Financial Research Corp., a Boston-based firm that compiles and analyzes data on the asset management industry.

While Mr. Quill predicts that some tax efficiency and cost advantages would be maintained, they may not be as overwhelming as with index products.

Boston-based State Street Global Advisors is the largest ETF manager, with $42 billion in assets and a market share of about 45%. Gus Fleites, director of exchange-traded funds at State Street, says that his company plans to offer actively managed ETFs. But he acknowledges that there are significant regulatory challenges.

Since the composition of index-based ETFs changes infrequently, investors and market makers know what the underlying asset value is. If the funds trade at a premium or a discount, market makers will step in and trade the funds until the price matches the net asset value. If active managers made their holdings public on a daily basis, traders front-running the funds could harm investors.

But, Mr. Fleites says, “there are a number of ways of satisfying the market-making community and the investor community, to tell them how a product may behave without having to actually disclose what’s in it.”

He suggests that active ETF managers should be required to disclose such factors as the size of the securities they are trading, the concentration of funds in particular market segments and industry sectors, and whether they trade stocks with high or low price-earnings ratios.

The managers should “describe the portfolio in as much detail as possible so investors and traders can get comfortable with how the fund is going to behave, without disclosing the actual holdings in the fund,” says Mr. Fleites.

Germany began trading in actively managed ETFs earlier this year. Managers of those funds are required to disclose portfolio holdings to a few market makers, who are charged with ensuring that the funds trade at fair prices.

But that approach is not expected to be acceptable to the SEC. “You’d basically be giving a monopoly to one or two firms,” says Mr. Fleites. “In the U.S., the approach has always been much more open.”

Joseph Keenan, vice president and global product manager of exchange-traded funds at the Bank of New York Co. Inc., which manages about $35 billion in ETFs, says the industry “has been anxiously awaiting this concept release.”

“This is part of an evolution of the ETF product in general,” Mr. Keenan says of actively managed ETFs. He argues that even index funds involve some stock picking, since they do not buy all the stocks being tracked. “If you optimize [by choosing the stocks to represent the index], are you not already making an active management decision?” he asks.