Active ETFs likely to receive a European tryout

LONDON — The first active exchange traded funds might be introduced in the United States within the next three to six months, according to sources close to negotiations between the Securities and Exchange Commission and Bear Stearns Asset Management Inc. of New York.
Since Bear Stearns filed a prospectus in March to launch YYY Trust, which will actively invest in money market and short-term fixed-income obligations, ETF managers have been keeping a close eye on the developments. If approved, it will be the company’s first ETF, as well as the nation’s first active ETF, potentially opening a door for others to introduce what could be one of the most important new investment tools in years.
But the Bear Stearns ETF is still relatively limited and doesn’t adequately confront some of the stickier issues associated with actively managed ETFs — for example, how to provide added value with proprietary stock-picking skills and still be completely transparent under current regulatory requirements.
Instead, some argue, Europe might be a more apt place to test the waters. A main reason is that regulatory requirements are less stringent, making it easier to introduce new ways of structuring ETFs, managers said.

Europe catching up
“Europe is catching up rapidly and in some ways passing the U.S.” in ETF innovations, said Greg Ehret, senior managing director and London-based European head of sales and distribution at State Street Global Advisors of Boston.
Both San Francisco-based Barclays Global Investors and SSgA, the two largest ETF managers in the world, with $285 billion and $101 billion in ETF assets under management, respectively, are trying to develop active ETFs. The Vanguard Group Inc. of Malvern, Pa., also has a fixed-income active ETF in registration with the SEC.
“Across iShares globally, we are considering ETFs designed to beat the market,” said Tim West, BGI’s London-based European chief operating officer for iShares. “I imagine we will do this in stages — the first ones being fund of funds that allocate among asset classes, and active ETFs comprising individual securities eventually will follow.”
Mr. West added that BGI might introduce its first active ETF as early as this year, but he declined to provide further details.
European ETF assets increased 63% to $89.7 billion in 2006, according to Morgan Stanley’s 2006 annual global review of ETFs. Although the number is relatively small compared with the $406.8 billion in ETF assets in the United States, this European “mind shift” in ETF investing has meant that the continent and the United Kingdom are becoming fertile grounds for new strategies in ETF management.
Société Générale Asset Management Alternative Investments is considered to be the first to go beyond a rules-based approach to include subjective views of the market, sources said. Its range of three “flexible” ETFs relatively track an index, but they are designed to offer investors more downside protection. Assets in this strategy are still relatively small, less than $272 million, but are expected to increase if general market conditions become more volatile.
SGAM’s analysts and fund managers adjust market exposure, based on trend and volatility expectations, quarterly, said Vincent Lauwick, London-based sales director of structured products. The aim is to guarantee a partial capital protection of 80% of the net asset value of the ETF from Dec. 31 of the preceding year.
“The ETFs are moderated toward uncertainty in the market,” Mr. Lauwick said. “They are meant to be complementary to two other ranges of ETFs — one that is leveraged long when investors expect the market to go up, and the other, the bear ETFs, when they expect the market to go down.”
Paris-based Société Générale Group, which offers ETFs through subsidiaries Lyxor Asset Management and SGAM, is now the largest ETF manager in Europe, with $22.6 billion in assets under management as of Dec. 31. Barclays PLC, the London-based parent company of BGI, has announced plans to acquire Indexchange Investment AG of Munich, Germany. The transaction would make BGI the top ETF provider in Europe, as it and Indexchange had combined assets of $43.4 billion as of Dec. 31.
European ETFs generally are structured according to the European Commission’s 2001 Undertakings for Collective Investment in Transferable Securities III directive, which is considered by many managers to be more flexible than the fund guidelines of the U.S. Investment Company Act of 1940. As a result, a number of new strategies in ETF investments — including commodities, long leveraged, short leveraged and private equity — have been introduced in Europe within the past several years.
Geoff Bobroff, president of Bobroff Consulting Inc. in East Greenwich, R.I., also said that Europe is the more likely place to “get the green light” for active ETFs.
“Once that happens, and a record is established, the SEC might be more willing to open a door,” he said. “Right now, I don’t think [the SEC] has the appetite to weigh in on that subject yet.”
Besides New York-based Bear Stearns, two other financial services companies — Firsthand Capital Management Inc. of San Jose, Calif., and Managed ETFs LLC of Summit, N.J. — have filed for exemptions that would allow them to offer active ETFs in the United States.
Jane Slater, a spokeswoman for Bear Stearns, declined to comment.
Gary Gastineau, co-founder of Managed ETFs and former senior vice president of product development at the American Stock Exchange, said that his firm is negotiating with the SEC to offer active ETFs in fixed income, equities and other asset classes. The company initially filed the application in August 2005 and doesn’t expect the SEC to reach a decision until 2008 at the earliest, he added.
“If you take a look at the structure of existing ETFs, and if you extend that to actively managed funds, you can create an investment structure that is better than anything else that is out there in terms of collective investment vehicles,” said Mr. Gastineau, who oversaw growth in ETF assets at the Amex from about $500 million in 1995 when he arrived to $34 billion at yearend 1999.
“The existing mutual fund structure hasn’t changed materially since 1924, and the process in which money goes in and out [of a mutual fund] hasn’t changed since 1968,” he said. “Yet there have been a lot of changes in terms of technology. We’re overdue for a substantially better product.”
The first ETF — SPDR 500 Trust — was launched in 1993 by SSgA and tracks the Standard and Poor’s 500 stock index. As of yearend, there were 732 ETFs with assets totaling $574 billion managed by 64 managers worldwide, according to the annual global review by New York-based Morgan Stanley.
Traditionally engineered using the main stock indexes, ETFs have evolved to include parameters that are often used in active management. Instead of market capitalization, the underlying indexes for some of the more recent ETF offerings are based on factors such as total cash dividends, free cash flow, total sales and book equity value. Leverage has also been used to fuel returns.
But as the line between passive and active ETFs begins to blur, so may some of the advantages of ETFs, said Marie-Pierre Ravoteur, Paris-based co-head of ETF development at AXA Investment Managers Ltd. of London. AXA IM has a partnership with BNP Paribas Asset Management of Paris to offer ETFs through the EasyETF Platform, which had $5.6 billion in assets under management as of Dec. 31.
One of the biggest challenges of active ETFs is transparency. If managers are required to disclose the underlying portfolio fully, they run the risk that other managers might front-run their strategies.
Furthermore, one of the main advantages of ETFs is that they allow authorized participants to create and redeem shares. Without full disclosure of the underlying portfolio, those participants, including arbitrageurs, may not be able to deliver an accurate basket of securities. Mr. Bobroff said: “Despite all this, many will still try, and they will get awfully close to a truly active ETF. But ultimately, it will depend on the ability to deliver on performance.”